Why small-cap stocks may be poised to play catch-up with the S&P 500

Small-caps have outperformed in May.

  • By Chris Matthews,
  • MarketWatch
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Stock-market investors have been on a wild ride since last summer, one that saw the S&P 500 (.SPX) decline nearly 20% before rebounding to hit a new all-time high in April.

Small-cap stocks haven’t been as kind to investors, however, as the Russell 2000 index (.RUT), remains 8.7% below its all-time high set back in August. But this long story of underperformance may be ending, strategists and investors tell MarketWatch.

“With U.S. large-caps breaking out to a record high, small-caps provide investors a potential opportunity for an asset class that has not fully recovered,” wrote Keith Lerner, chief market strategist at SunTrust Private Wealth, in a Tuesday note to clients.

“Over the past year, small-caps have trailed large-caps by about 7%,” he added. “This is among the weakest underperformance periods for small-caps since the start of this bull market. This is also a level at which small cap performance relative to large-caps have tended to improve.”

Indeed, this turnaround may have already begun: Since May 1, the small-cap Russell 2000 index has lost just 0.8%, versus a 2.4% decline for the S&P 500 (SPX), and a 2.6% fall for the Dow Jones Industrial Average (.DJI).

The outperformance of the Russell 2000 comes during the most trying time for stock-market bulls so far this year, with hopes of a near-term resolution to the U.S.-China trade dispute dissipating after U.S. officials threatened to raise tariffs on roughly $200 billion in goods imported annually from China from their current 10% to 25%, as soon as Friday. Between Monday and Tuesday alone, the S&P 500 fell 2.1%.

“Based on the historic ratio between price-to-earnings on the small cap index versus large cap, we’ve moved beyond neutral, and small-caps are now cheaper than the historic average,” Craig Callahan, president of Icon Investments told MarketWatch. “While not at extreme levels, it is pointing toward a place where small-caps can be a future leader.”

Steven DeSanctis, small-and-mid-cap equity strategist at Jefferies, wrote in a research note that from Feb. 22 to April 22 the small-cap Russell 2000 index trailed the S&P 500 by 5.7%, “and so now small looks very attractive vs. large.”

Investors looking to reallocate from large cap companies to small one should be mindful of differences in sector performance. Callahan told MarketWatch that he invests in consumer discretionary, industrial, tech and financial companies, with financials particularly undervalued given that smaller banks have proven an ability to be profitable during times of low interest rates. Since May 1, the Invesco S&P SmallCap Financials ETF (PSCF), has risen 0.2%, while the major benchmarks have posted significant losses.

Paul Hickey, co-founder of Bespoke Investment Group pointed to industrials as a small-cap sector worth watching, in a Monday-evening research note. He wrote, “In the case of industrials, there is a legitimate case to be made that small-caps face less ‘trade war risk’ than larger companies that have overseas exposure to China or exports more generally.”

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