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Here's why small caps are beating the S&P 500 this quarter


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Trading Nation: Small caps outpace S&P 500 since March bottom, can it continue?

Small caps are joining in on the market rally.

The Russell 2000 has bounced 56% since the March bottom, outpacing the S&P 500's 46% run over the same stretch.

Todd Gordon, managing director of Ascent Wealth Partners, says two groups have contributed the most to the small-cap rally. The first, financials as measured by the PSCF small cap financials ETF, has surged nearly 16% just this month.

"It's been outperforming the Russell only recently … most likely in response to U.S. Treasury yields moving up," Gordon said Tuesday on CNBC's "Trading Nation." Higher yields benefit banks' profitability, often giving their stock prices a boost as well.

"It's not unique to small caps [though]," said Gordon. "You're also seeing it in large-cap financials — the XLF — to the S&P 500, so it's broadly financials coming back here from oversold status."

The XLF, which tracks mega-cap banks such as Citigroup and Bank of America, is up nearly 12% in June.

"The other one is health care, as measured by PSCH, a small cap ETF that tracks health care. You've actually seen a pretty good move up on the upper panel, but the lower panel shows the ratio of health care into the small-cap Russell benchmark and that strength has been falling off. So we think it's kind of isolated to a couple story stocks like Teladoc or Regeneron," said Gordon.

Gina Sanchez, CEO of Chantico Global, says small caps' performance is closely tied to the U.S. economy and expectations on recovery from the coronavirus pandemic.

"They were definitely the group of stocks that was expected to have the most impact by Covid-19 and I think that that is still the case. And so, as we have seen some positive news rolling through the macro data, the idea that we're starting to reopen and we're starting to turn the corner, I think that there is a concern that some of the pessimism that was priced into those markets needs to be taken off," Sanchez said during the same segment.

However, one factor is holding Sanchez back from fully backing small caps.

"These are not good value right now. Right now, the small cap segment is very highly overvalued, so I think it's a very cautious play at the moment," said Sanchez.

The IWM Russell 2000 ETF trades at 51 times forward earnings, well above the S&P 500's 23 times multiple. 

Disclosure: Ascent Wealth Partners holds the IWM ETF.