Market Insider

Investors are waiting on small caps to join the Dow at a record to 'signal a stronger bull run'

Key Points
  • The Dow Jones Industrial Average joined the S&P 500 and Nasdaq at all-time highs Monday, but the small-cap Russell 2000 is way behind, still about 8% from its high.
  • Strategists say a move back to the highs for the Russell would add fuel to the market's rally and confirm the highs.
  • The Russell 2000's move is heavily dependent on progress in the U.S. economy and it has outperformed over the past month.
  • The question now is whether it's set to take off into year end.

The Dow Jones Industrial Average on Monday was the last of the three major stock market indexes to regain its high, but if the lagging small-cap Russell 2000 can join in, that could signal a stronger bull run.

The Dow opened at a new intraday high on Monday, and traded in record territory along with the S&P 500 and Nasdaq. The market is getting a lift from positive developments in trade talks between the U.S. and China, but is also entering what historically is the best six months of the year for stocks.

Small caps have been outperforming recently but are still a sharp 8% away from the all-time high of 1,742 in the Russell 2000, on Aug. 31, 2018. It is still 1.2% away from its 52-week high of 1,618.

Over the past three months, the Russell 2000 was up 4.3% while the S&P 500 was up 5.1%. But in the last month, the Russell has increased its pace of gains, and is up by 7.6% to the S&P 500's 5.8%.

Scott Redler, partner at T3Live.com, said small caps could become part of the fuel that keeps stocks rallying into year-end. He follows short-term technical moves and has been watching the iShares Russell 2000 IWM ETF that tracks the Russell 2000.

The IWM is edging close to its 52-week high of $161, trading at just under $159.

"A pause here would make some sense since it just hit the high end of the range. If it could hold here and not pull back much, it would breed some confidence for a real breakout towards the August 2018 highs," Redler said. "If IWM gets above and stays above $160, it could see a move back to its old highs." The IWM hit a high of $173.39 in August 2018.

Small caps could see a pullback in the next couple of sessions because the market has become overbought, and Redler said it will be important to see what happens after that move. "The heavy lifting since August in the S&P was led by tech, the homebuilders and some financials. If the market keeps rotating, this could be a viable group to sustain the move," he said.

Jonathan Golub, chief equity strategist at Credit Suisse, said he has more conviction in the stock market's move higher, and he expects a continued turn toward cyclicals, and small caps should benefit.

"They've lagged the market through most of the cycle and if my call is right that interest rates rise and the economic data in the U.S. and globally has bottomed, then absolutely they are a winner in this environment," said Golub.

He said small caps should be part of the leadership. "The call would be over the next three to six months — value over growth, small over large and more cyclical stocks over more stable, low vol names," he said.

Analysts see the potential for a small-cap move, but not all are embracing them wholeheartedly from a fundamental perspective.

"Optimism that the industrial economy has bottomed has triggered the recent stabilization in Small Cap relative performance. We'd like more evidence that a turning point, rather than a tipping point or a continuation of a positive but sluggish growth backdrop is at hand before moving to an overweight," notes Lori Calvasina, chief U.S. equity strategist at RBC.

But Calvasina said small-cap valuations look only modestly overvalued, and they are undervalued relative to large cap.

"When we compare Small Caps to Large Caps on our multi-factor model, we continue to find that Small Caps to look deeply undervalued, 1.25 standard deviations below the long-term average," she wrote. "The valuation gap is striking and suggests that investors on the hunt for Value should look at smaller names. The relative multiple for Small Cap remains well below mid 2016 lows and the most compelling valuation reading that we've seen for Small Caps on a relative basis versus Large Caps since 2002."

Jefferies points out that the price-earnings ratio for the Russell 2000 is now 20.6, the highest since December 2018, but that is not so much of an issue since negative earnings revisions may have peaked. The forward P/E for the S&P 500 is about 17 times.

"We may have seen the last of the broad cuts in earnings and sales revisions for the small caps, as they ticked up last month. We have been looking for a real catalyst and not just valuations and this may be it," said equity strategist Steven DeSanctis, in a note. He expects small caps have the potential to outperform by 6%.

He expects small-cap earnings for the third quarter will be down single digits, versus the expected double-digit decline, and large-cap earnings should be down between 2% and 4%.

"The question is does this mean that 2020 is really easy and with decent economic growth, it provides a good set up for small caps? We are increasingly in that camp, although we certainly do not feel good about it, as we have been looking for an improvement in growth," DeSanctis said.

DeSanctis, in a phone interview, said small caps do not have to hit a new high to keep the rally going, but it helps if they continue to move higher on an improving outlook. "If earnings growth gets better and broadens, that leads you to cyclicals outperforming, and small caps go a long with that," DeSanctis said.

He said that other measures for small caps did not move up as much as forward P/E. "Large caps are really stretched on an absolute basis with our model standing in the 91st percentile versus 89th last month," he wrote.

Calvasina also said investors see small caps as the purest play on the U.S. economy and a place to put more money to work when the U.S. looks like it's improving.

"There are a few data points that help to support this claim. Small Cap performance relative to Large Cap generally tends to move in sync with trends in the Chicago Fed National Activity Index, Cass freight shipments, and the yield curve," she said.

The yield curve had been inverted during the summer, but in the last month, while small caps outperformed, the curve had steepened.