Small cap stocks have been racing ahead of large caps since February, and should continue to outperform despite their relatively high prices.
Despite this week's selloff, analysts still see plenty of upside for small caps simply because they are less exposed than larger companies to overseas markets, where U.S. companies may find their products taxed or other retaliation due to trade disputes.
"A lot of the money coming into small caps is generated by trade jitters. It's gotten to the point, where we can't keep hoping trade will go away as an issue. This is part of the reality that's coming out of Washington," said Lori Calvasina, chief U.S. equity strategist at RBC.
Since the start of the year, the Russell 2000 is up 6.8 percent but the is only up 0.9 percent. The Russell has slipped more than 2.7 percent this week, slightly more than the broader market, after scoring gains for eight weeks straight. The Russell set a new high last week of 1,708 and closed at 1,640 Wednesday.
"From the low in February...small cap ETFs have taken in $12 billion since then. That's a large amount of money in a very short period of time," said Steven DeSanctis, U.S. equity strategist at Jefferies. "The Russel's flirting with 1,700 but I can see upside because the sentiment is so good, but the performance has been really fast...This is just the fact that people want to own small cap because of trade wars."
"Small caps is like the teflon asset class. We initially saw the money rotating out of large caps in March. Then EM started to unwind, and you can see pretty clearly as money started to rotate out of emerging markets, small caps got a second wind," she said. "Small caps right now are the safer risk trade."
Small caps are normally considered the riskiest group in the U.S. stock market because of their high volatility. When they lead, it usually signals an appetite for risk.
But it seems investors have been using small caps as insulation against the volatility from trade wars. About 80 percent of small cap revenues are domestic and that means they have far less direct impact from tariffs or other trade retaliation than large caps.
"I just think there's a general sentiment that is really strong, and it's hard to turn the sentiment around, especially if we get a good Q2 reporting season which we're looking for," DeSanctis said. "We have not seen a decline in the 2018 earnings growth number." He said that's important since there usually are revisions by this time of year, and sales growth expectations are rising. DeSanctis said small cap earnings are expected to grow by 26 percent for the full year.
Calvasina said she recently went to overweight from neutral despite the fact the small names have been on fire this year. She said the trade is in its "middle innings."
"We 're still constructive directionally but we expect the pace of gains to decelerate. I don't think it's up, up and away. I think it's more a stretch higher. It's more about a relative call versus large," Calvasina said, adding she expects the smaller names to hold up better during bouts of market turbulence this year.
She does warn, however, that if trade disputes escalate, the slam to large cap companies could ripple across small cap companies who have them as customers. Trade wars that
"There are no winners in a trade war. Small caps will have their issues. We do expect the pace of gains to moderate here," she said. "Consumer discretionary is one of the interesting sectors in small caps but they import a lot of goods from overseas."