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Net Net: Promoting innovation and managing change

Small caps rake in big bucks; top week in 14 years

Russell 2000 on track for weekly gain
Russell 2000 on track for weekly gain

A volatile week for financial markets has produced at least one clear winner.

Small-cap stocks, previously Wall Street's biggest laggards, took on a leadership role as the market bent and swayed in a storm of tumult that provided unpleasant reminders of the financial crisis.

While major indexes including the and Dow Jones industrial average sustained huge swings that resulted in comparatively modest losses, the —the primary index for small caps—had risen an impressive 3.7 percent as of Friday morning trade.

The performance was especially impressive considering the barometer had actually entered official correction territory—down more than 10 percent from its most recent high—as investors abandoned the space.

Money flows drove the performance, with one exchange-traded fund in particular reaping the benefits.

Why small caps are rallying
Why small caps are rallying

The ETF pulled in $2.93 billion of investor flows for the week, the most of any fund and more than triple its closest competitor, the Energy Select SPDR, which saw inflows of $766.1 million.

Among market watchers there were several explanations: The group likely had become cheap after suffering through a huge autumn discount. Investors also were looking for U.S.-centric plays amid global weakness, particularly in Europe. And for some, the move showed a healthy general appetite for risk despite all the market ups and downs.

"With the tailwind of strong, resilient, US economic data (jobless claims, manufacturing) small caps are now finally outperforming large caps in the stock market, high yield is outperforming investment grade and interest rates ended (Thursday) modestly higher," Hans Mikkelsen, credit strategist at Bank of America Merrill Lynch, said in a note to clients. "These developments are encouraging and support our view that the financial markets' reaction to global weakness is overdone."

Interestingly, a separate report from BofAML's chief investment strategist, Michael Hartnett, issued a caveat that the flows could be "ETF creation for new shorts," implying traders trying to push momentum in a space that they then seek to bet against.

But David Rosenberg, economist and strategist at Gluskin Sheff, said the overall move—the best Russell 2000 week in 14 years when comparing performance to the S&P 500—in small caps should help assuage those worried that the market is heading for more trouble.

"The privates and lieutenants always lead the colonels and generals and always in both directions," he said in his daily note. "This could be a very key confirmation that we are past the eye of the storm."