US Markets

Tom Lee says the market is flashing a buy signal on small-cap stocks

FANG ends with a 'dang' (buy last year's losers): Pro
FANG ends with a 'dang' (buy last year's losers): Pro

Investors have been rewarded for following signals in credit and derivatives markets this year, and a new one recently started sending a buy signal for small-cap stocks, according to Fundstrat Global Advisors co-founder Tom Lee.

"I think a really strong message is coming to buy small caps, because when economic data picks up and credit eases, small caps almost always win," he told CNBC's "Squawk on the Street" on Monday.

In a note, Fundstrat pointed out that the quality spread between noninvestment credit rated BB versus CCC narrowed to 538 basis points over the last six months, something that has only happened three times in the last 25 years. When this happens, small caps have outperformed the 73 percent of the time and posted 13 percent absolute gains over the next six months.

Fundstrat notes that the relationship is somewhat intuitive because riskier assets tend to benefit when credit conditions ease.

Lending further momentum to small caps, the firm sees fiscal stimulus — particularly in the G-4 nations of Brazil, Germany, India and Japan — picking up after five years of fiscal drag. Coming at a time of ultra-accommodative interest rates, the stimulus will be particularly effective and boost stocks, in Fundstrat's view.

Lee said investors should also keep their eyes on the market's laggards.

"The industrial recession's ending, so you want to be more cyclical — tech, industrials, basic materials, energy," he said.

Heading into year-end, Lee said Fundstrat is still bullish but a bit conflicted, as the potential for an interest rate hike from the Federal Reserve and the presidential election raise the risk of higher volatility, he told CNBC.

Still, Fundstrat sees markets putting up further gains into year-end, as investors have a lot of money on the sidelines and therefore have dry powder to chase performance.