Small caps could be getting ready to make a move higher — how to play it

Published Wed, Sep 1 20212:55 PM EDTUpdated Wed, Sep 1 20214:54 PM EDT

Patti Domm @in/patti-domm-9224884/@pattidomm

After lagging for months, it may be time for small caps to shine once more. "I think we're going to have a burst of outperformance," said Steven DeSanctis, U.S. equity strategist at Jefferies. "The sentiment is starting to turn a little bit. ... Small caps lagged in August by 30 or 40 basis points, but the last two weeks have been better." The Russell 2000, a popular small-cap index, peaked March 15, hitting a high of 2,360, but since then it has struggled to recover its old high as indexes like the S & P 500 hit new high after new high this summer. Many traders invest in the Russell through the IWM iShares Russell 2000 ETF. Other exchange-traded funds that focus on small caps include the Vanguard Russell 2000 Growth Index Fund ETF , iShares Russell 2000 Growth ETF IWO and the iShares Russell 2000 Value ETF IWN. There's also the Invesco S & P SmallCap 600 Revenue ETF RWJ; the Invesco S & P SmallCap Value with Momentum ETF XSVM; and Vanguard Small-Cap Growth Index Fund ETF shares VBK, among others. The Russell 2000 index closed Wednesday at 2,286, up 0.6%. The Russell was 2.1% higher in August, compared with a 2.9% gain by the S & P 500. On a chart basis, some analysts say it also looks set to break out. "As long as the Russell 2000 is above 2,260, I think that scenario is on the table," said Ari Wald, technical analyst at Oppenheimer. "The action last week was significant in our work because it marked a reversal of a near-term downtrend in the Russell 2000. It moved above its prior peak, making a higher high. It's been this tough consolidation period for the Russell in the last few months. It's showing some signs of trying to move higher." Wald said the next level to watch is 2,360, the previous high. "The small caps are the tell. As long as they hold and start moving higher, it should be good for the market," he said. Wald said the market is heading into a seasonally difficult time but investors should look ahead to potential fourth-quarter gains. "We've had this internal correction. It wasn't as deep as we thought," he said. "There are signs we are starting to inflect higher, given the action in the Russell 2000. We're still in this weak seasonal window. September isn't really a time to expect a breakout but long-term investors should think about that." But he added as long as the Russell holds the 2,260 level, the chances of a September seasonal correction are lower. Wald said he likes technology because it should have a more steady performance than some other groups, and it is a sector that is a good investment across the range of market capitalizations. Analysts say the action in small-cap stocks is tied to a bigger trade, and they move higher with value names and cyclical stocks. Many analysts expect value and cyclicals to begin to outperform into the end of the year, as the latest Covid outbreak peaks and the economic data improves. "To me, the biggest thing that's happening here is Covid and delta," said James Paulsen, chief investment strategist at Leuthold Group. "We're setting ourselves up for a second round of a mini reopening where delta peaks and when it does, confidence returns, jobs reports pick up and that should take portfolio managers back towards cyclicals, small and international stocks. Paulsen said small caps were rallying when the 10-year Treasury yield was moving higher in the spring, but then headed lower as rates fell. The closely watched benchmark 10-year hit a low of 1.12% on Aug. 4, and was at 1.30% Wednesday. That compares with 1.75% at the end of March. "They're not cheap because their fundamentals are poor. They're cheap despite incredible fundamentals," Paulsen added. DeSanctis said small-cap earnings will be up 40% in 2021, compared with 2019 profits. For large caps, estimates are 25.5% higher than 2019. "This time last year, large was better than small," he said. "The earnings look good for small. The estimates keep going up, but I don't think that investors believe the good times are going to last," he said. DeSanctis points out that the S & P 600, a small-cap index, has outperformed the Russell this year, and was up 22% through the end of August. In the same period, the Russell was up just more than 15%, while the S & P 500 rose 20%. The S & P 600 has more value names, while the Russell has a high level of volatile biotech stocks, he said. -- CNBC's Michael Bloom contributed to this report.

Traders on the floor of the New York Stock Exchange, August 11, 2021.

Source: NYSE

After lagging for months, it may be time for small caps to shine once more.