What to know about small caps, the little stocks having a big moment

A market dominated by megacap tech in 2024 has recently undergone a vibe shift: Small cap stocks are having a moment.

The Russell 2000 Index, a key benchmark of small cap stocks, bested the S&P 500 by nearly 10 percent in a five-day span — the largest outperformance on record. 

The durability of this about-face in market leadership remains an open question, but investors have certainly been voting with their feet.

Through Wednesday, the five-day net flows into the biggest ETFs that track the Russell 2000 and S&P SmallCap 600, another small-cap gauge, topped $6.7 billion — the highest level on record.

Here’s a primer on small caps for anyone who’s just learning that there’s more to the stock market than the “Magnificent Seven.”

What are small caps?

As the name literally entails, small caps are companies with a smaller market capitalization than the firms who make up the S&P 500, Russell 1000, Dow Jones Industrial Average, or any other so-called “large cap” index.

Typically, small caps thought to be a better gauge of the underlying health of the US economy because more of their revenues are generated domestically (especially compared to the multinational behemoths atop the S&P 500). And while that shorthand explanation has more than a kernel of truth, it’s also a bit misleading — depending on which small-cap benchmark you choose to buy.

What are your options?

The Russell 2000 is the more commonly quoted gauge of small-cap stocks in the financial press. But, in the ETF space at least, the dominant vehicle is tied to the S&P SmallCap 600 — the iShares S&P SmallCap 600 ETF, with nearly $83 billion in assets. The iShares Russell 2000 ETF has a little less than $69 billion in the fund.

What are the similarities and differences between the two indexes?

Financials are the dominant sector for both small cap benchmarks, making up almost one-fifth of each index.

One key criteria in how the two indexes are constructed, however, makes a huge difference to the overall composition and returns: the S&P SmallCap 600 requires that its constituents be profitable, and the Russell 2000 does not.

On a sector level, the biggest difference between the two benchmarks is that the Russell 2000 is far more exposed to health care stocks (read: mainly unprofitable biotech firms) — whose weighting is roughly 7 percentage points above that of the S&P SmallCap 600. The S&P 600, meanwhile, has more exposure to consumer discretionary stocks. 

You can almost think of the Russell 2000 as a blend of US regional banks (which are fairly sensitive to the economic cycle) and biotech companies (whose success and failure is more dependent on the trials of the drugs they’re attempting to develop).

Over the past decade, the price return of the Russell 2000 is less than 5% above a simple 50/50 split of the SPDR S&P Regional Banking ETFand the iShares Biotechnology ETFs, while the S&P SmallCap 600 has done far better.

Does the S&P SmallCap 600 normally outperform the Russell 2000, or was this an exception?

The built-in higher quality due to a profitability requirement is one key reason why the S&P SmallCap 600 has tended to outperform the Russell 2000 over time. Since the S&P SmallCap 600’s inception (the end of 1993), it’s outperformed the Russell 2000, with the scoreboard at 1280% to 742%, respectively.

And over every rolling six-month period since inception, the S&P 600 has beaten the Russell 2000 more than 60% of the time. Of course, over shorter-term horizons — like this one — the Russell 2000 has demonstrated the capacity for particularly sharp rallies that can leave the higher-quality small cap gauge in the dust.

Why are people interested in small caps right now?

Well, the obvious answer is: look at how well they’ve done very recently — especially compared to other indexes! Over a decade ago, hedge funder Richard Taglianetti delivered a line that I haven’t forgotten: “Performance is a magnet for assets.”

Beyond that, there’s a trifecta of reasons why investors are betting on a relative improvement in small caps’ fundamentals:

1. The Federal Reserve is widely expected to lower its policy rate in September, and smaller firms have more floating-rate debt (on which the interest payments would be reprised downwards) compared to larger firms.

2. The likelihood of Donald Trump recapturing the presidency and Republicans emerging victorious in the House of Representatives this November has increased. This would seem to make the extension of tax cuts from Trump’s first term more likely, and these provisions tend to benefit small firms more than bigger ones.

3. Trump’s presumed trade policies (tariffs and the like) are more of a headache for larger firms than small caps.

Is there anything I should be worried about?

In our eyes, the best case against jumping on the small cap bandwagon comes from Michael Purves, CEO and founder of Tallbacken Capital Advisors.

His arguments:

• The recent outperformance of small caps versus large is about as much as after Trump unexpectedly won the 2016 election, so that catalyst might not have much more legs. And there’s plenty of time between now and November for the electoral winds to change.

• The Russell 2000 has rallied this year due to multiple expansion much more so than an expected improvement in earnings growth (for large caps, it’s been a more balanced split between higher earnings-per-share projections and richer valuations). And large caps tend to grow earnings more than small-cap firms.

• At a technical level, the price ratio of the Russell 2000 versus the S&P 500 has reached extremely overbought levels (as judged by the relative strength index, a measure of the magnitude and persistence of price movements). The last three times we reached these kinds of overbought levels were good sell signals for the Russell 2000 relative to the S&P 500, he says.

“​​Is there a good reason to think that the Russell 2000’s aggregate earnings are going to now accelerate, or is this surge more about algos cloning a 2016 playbook?” writes Purves. “With earnings season just unfolding, we suspect the usual suspects (big tech) are once again going to demonstrate superior earnings growth and the resiliency and power of their business models.”