Will this surge in small cap stocks have a happier ending?
In July, elevated investor exposure to the stock market meant that small cap and large cap strength could not coexist.
Here we go again.
Small cap stocks – which give investors exposure to publicly traded US companies that aren’t big enough to be in the S&P 500 – are once again on fire.
The Russell 2000 is on a seven day winning streak – matching its longest consecutive string of gains over the past three and a half years. The popular small-cap index is up 7.4% over this period, while the S&P 500 has gained only 4% over the same stretch.
The longest winning streak for small caps in the past decade was their 15-day run in the days leading up to, and following, the 2016 presidential election. Unlike the S&P 500, which closed at a record high on Thursday, the small-cap gauge remains about 8% shy of its November 2021 closing peak.
This re-embrace of small caps comes at a time when the performance of some defensive pockets of the market – namely, the low-volatility stocks that went on a record streak of gains recently – have begun to flatline.
This suggests investors are willing to embrace more volatile parts of the stock market after getting a little more comfortable with the economic outlook as the Federal Reserve begins an easing cycle.
“A ‘catch-up’ in the sectors and factors that tend to do well during expansions should be expected as the risk of a slowdown spiral decreases,” writes Dennis Debusschere, chief market strategist and founder of 22V Research. “Particularly those sectors that have lagged meaningfully (value, small, debt risk).”
But as we saw all too well in mid-July, a strong spurt for the Russell 2000 is no guarantee of future success for small caps or their larger peers.
“Compared to all periods since 1980, the Russell 2000’s performance following all seven-day winning streaks is very similar to even slightly better than the historical average,” write analysts at Bespoke Investment Group. “However, when you look at winning streaks since 2003, the Russell 2000’s performance has been notably weaker than average.”
One fly in the ointment with the small cap surge in July: it seemed like to get into small caps, investors had to sell out of something else – namely, megacap tech shares. Small cap and large cap strength did not coexist.
That was likely a function of the overall enthusiasm for stocks that was shaken as the S&P 500 fell from its mid-July record highs, but may have been rebuilt as the benchmark gauge reclaimed and surpassed those levels. While no one positioning indicator is perfect, one gauge from the National Association of Active Investment Mangers that shows how much exposure their members have to stocks is below its early July levels – but not by much.
That hasn’t happened so far: through Thursday’s close, Magnificent 7 stocks are up more than 10% over the past 10 sessions, while small caps gained 6.6%. It’s the first time both cohorts outperformed the S&P 500 by more than 2 percentage points over a two week span in over a year.
If the market is getting a little less worried about the economic backdrop thanks to central bank support, a “July redux” looms as the new potential dynamic to lose sleep over (again).
