The monster rotation is gaining steam.
This is very healthy action that’s long overdue.
Here are 3 reasons small-cap stocks are heading a lot higher.
Yesterday’s 3.65% selloff in the NASDAQ 100 was the worst since 2022. All major indices got clobbered, but mega-cap Tech in particular felt the brunt of the latest market-cap reshuffle.
While some may point to earnings or economic worries as the culprit, the downshift is really a function of supply and demand mechanics.
Large underperformance by small-caps and the average stock, caused positioning to reach extremes – where a handful of mega-cap equities attracted the lions-share of investor capital.
While a lot of damage has occurred in the market thus far, and some tech names are starting to get interesting, I see small-caps as a top bet in the coming months and longer.
Today we’ll begin by assessing the current state of the market. Then we’ll dive into 2 evidence-rich studies that signal small-cap leadership has plenty of room to run.
Markets are moving fast. On a 3-month basis, small-caps are the best performing equity class.
As you can see below, the Russell 2000 has ripped 11.2%, easily beating the NASDAQ’s gain of 9.41% and the S&P 500’s lift of 7.87%.
Reason number 1 to keep a healthy allocation to small-caps comes down to their new leadership position:
Just a month ago, if you’d uttered an overweight allocation to small-caps, you’d have been greeted with flying tomatoes.
But as we learn time and time again with markets, money rarely leaves equities…it simply rotates.
Investors hop from one area to the other when they believe a better opportunity exists elsewhere.
Below shows how violent the pendulum swings. The relative performance of the Russell 2000 ETF (
$IWM) and the NASDAQ 100 ETF (
$QQQ) is eye-catching.
When the blue line surges higher, it indicates investors are selling mega-cap tech to fund long bets on small-caps:
In that non-consensus piece, we showed how small-caps perform best when interest rates fall.
Looking back at an image from that post, you’ll note how the S&P Small Cap 600 has an inverse relationship with the 10Y Treasury yield.
When rates dip, small-caps rip:
Reason number 2 to bet big on small-caps, boils down to the fact that the Fed is nearing its first rate cut. The June CPI reports effectively clinched a September ease.
As of this morning, odds of a 25bps cut stand at 80% for the September meeting…odds of a 50bps cut have now climbed to 18.7%.
This is critical when you marry this information with the fact that the US economy is still humming along…avoiding a recession.
This is one of my favorite charts for today.
Since mid-1995, when the Fed first cuts rates and the economy isn’t in recession, and doesn’t fall into one a year later, small-caps absolutely soar!
A month after the first rate cut, the S&P Small Cap 600 gains 4.8%.
3-months later, small-caps see a 10.6% gain.
12-months post the first rate cut; small-caps surge 19.3%
Hopefully you’re beginning to see this rotation for what it truly is…a big fat opportunity!
But there’s one other signal that favors a big bet on small-caps. And it comes down to recent rare thrust signal.
Last Tuesday, July 16th, the Russell 2000 did something extraordinary. The index gained 3.5%.
On the surface, that may seem like an overbought signal. Afterall, who wants to buy something after such a powerful up-move?
Turns out that since 1984, a gain of 3.5% or more for the Russell 2000 has only occurred 107 times. That shakes out to roughly 2.5 times a year.
Reason number 3 to beef up your small-cap allocation comes down to the market-beating gains that follow a daily gain of 3.5% or more.
If you aren’t ready to scoop up small-caps just yet, this next study should change your mind.
Here’s what happens after the Russell 2000 gains at least 3.5% in a day:
- 3-months later RUT climbs 4.3%
- 12-months later the Russell surges 27.7%
- Be bold with a 24-month hold and you’re staring at a historical average rally of 40.9%
Ladies and gentlemen, I’ve just presented 3 reasons small-cap stocks are heading a lot higher.
Recent leadership, a falling rate regime, and a power thrust signal tell you all you need to know.
Couple those data-driven reasons with the fact that 85% of all inflows in our data since the June CPI are in companies of $50B or less market-cap, and you’ve got the tailwind pointing due North for small-caps:
This means new leadership is here. Financials, Industrials, Discretionary, and REITs are the money-flow magnets.
Don’t listen to the fear-driven media. You’ll miss what’s actually happening: a renaissance in prior unloved areas.
If you’re not excited about tomorrow’s opportunity – it might be time for you to consult a map!
Let’s wrap up.
Here’s the bottom line: Major indices are under pressure. That’s giving way to new leadership under the surface.
A powerful rotation has taken Wall Street by storm…and it’s got further to go.
Not only are small-caps the best performing equity class the last 3 months, they’re also poised to surge once the Fed starts easing policy in September.
Couple this with a 3.5% rare ultra thrust last Tuesday, and you’re staring at a big fat upside signal in smaller unloved stocks.
Our data points to healthy institutional buying in Financials, REITs, Industrials, and select Discretionary names.
As I like to say, tomorrow’s leaders can be found today…just follow the money.
The small-cap bells are ringing loud and clear.
It’s true…sometimes Christmas comes in July.
Have a great week!
