Small Cap Stocks Have More Room to Run
The rally in small-cap stocks is just getting going…
Since the U.S. presidential election on November 5, small cap stocks have been on a tear. In a little over two weeks’ time, the Russell 2000 Index jumped 4.8%. That would put it on pace for an annualized gain of close to 110%...
The driver behind this surge is the perceived policies of President-elect Donald Trump. On the campaign trail, he stumped on a platform of boosting domestic manufacturing and jobs. He has said he will introduce tariffs on foreign-made goods. In addition, he said he would cut taxes for companies that produced goods in America.
Wall Street has been quick to get on board. You see, the small-cap heavy Russell 2000 is made up mostly of companies who do business in the U.S. Those index-member entities draw roughly 81% of their revenue domestically. according to the financial-services firm Morningstar.
Since peaking in late 2021, the Russell 2000 is finally starting to break out. It’s on the verge of making new highs for the first time in just over three years. For perspective, the S&P 500 and Nasdaq Composite Indexes have been in that same trend since the start of this year. And based on what I see, small-cap stocks are headed even higher.
But don’t take my word for it, let’s look at what the data’s telling us…
Let’s start with a chart of the Russell 2000 over the last three years. In the below graph, you’ll notice the prior peak of 2,442 set back in November of 2021 on the far left. Then, over on the right, you can see the measure is just below surpassing that level…
Given Wall Street’s optimism, analysts currently predict earnings growth of 11.3% next year. That’s on top of expected 16.4% growth in 2024. The index has gained 16.6% as a result. Yet, it has massively lagged the performance of the large-cap focused S&P 500. Analysts are predicting member companies in that gauge experienced earnings growth of 9.3% this year and will see another 15% increase in 2025. Yet, the index is up over 25% since breaking to new highs late last year.
But this is a pattern that has played out before. In fact, it has happened three prior times since 2010. That implies small-cap stocks have some catching up to do compared to their large cap brethren. And when that rally is triggered, the Russell 200 has averaged a 40% gain before the next peak.
So, let’s take a look…
In the above chart you’ll notice the Russell 2000 peaked in September 2018 at 1,728. Over the following couple of years, the gauge moved sideways as the Federal Reserve was raising interest rates. Then, you can see it collapses with the COVID crash in early 2020.
It’s not until the domestic economic recovery in late 2020 that the small cap gauge starts to recover. In November 2020, the index finally made a new closing high at 1,747. The rally finally stalled in November 2021 when the gauge closed at 2,442. In those 12 months, it rose 39.8%.
We see the same scenario play out between 2015 and 2018…
As you can see in the graph, the Russell 2000 peaks in June 2015 at 1,294. From there it experiences a steady drop into early 2016. At the time, investors were worried about collapsing economic growth in China. But then, once fears of a global meltdown are assuaged, small caps stocks start rallying once more. By late 2016, the small-cap gauge finally hits our trigger point, closing at 1,298. Finally, after rallying for 22 months, the index peaks in September 2018 at 1,740. Over that time frame, it gained just over 34%.
Now let’s look at our final example. We see the same setup and outcome play out between 2011 and 2015…
In May 2011, the Russell 2000 peaks at 865. Then it experiences a steady sell off into October as investors worried about a European debt crisis and slowing U.S. economic growth. Then the Federal Reserve announced plans to buy $600 billion worth of U.S. Treasurys. The shift eased liquidity concerns and stocks started rallying once more.
By the end of 2011, domestic stock markets had recouped the bulk of the losses experienced earlier that year. And by the start of 2013, they were breaking out to new highs. In January of that year, the Russell 2000 made a new closing high of 873, hitting the next trigger point. The rally kept going until June 2015 when the next peak was made at 1,294. During that span, the index gained over 48%.
Like I said at the start, small cap stocks are on the verge of breaking out. The Russell 2000 is rapidly approaching new highs. Based on the past three times we’ve seen this scenario play out, the index has averaged a 40% rally over the following 21 months. And if the incoming administration of President-elect Trump can fulfill its campaign promises for boosting domestic growth, we should see small caps making new highs sooner than later.
If you’re interested in investing in this trend, take at look at the Vanguard Russell 2000 ETF (VTWO). Invests in stocks in the Russell 2000 Index, seeking to track the gauge’s returns. It trades about 1.7 million shares a day so it should be easy to buy and sell.
Based on the above chart of the fund’s performance compared to the SPDR S&P 500 ETF (SPY), there’s a ton of upside potential. The Vanguard Russell 200 ETF is up 99% over the last 10 years compared to the SPDR S&P 500 ETF’s 186% gain. The current performance gap is the one of the largest over that time frame.
Five Stories Moving the Market:
China is willing to conduct active dialogue with the United States based on the principles of mutual respect and promote the development of bilateral economic and trade relations, vice commerce minister Wang Shouwen said Friday – Reuters. (Why you should care – China is signaling it would like to avoid a trade war)
U.K. consumer confidence improved this month in a positive sign for household spending ahead of the vital end-of-year shopping season – WSJ. (Why you should care – the data point to the potential for Bank of England rate cuts)
New data from the New York Federal Reserve’s market liquidity index showed bank reserves remain abundant; the numbers suggest the U.S. central bank isn't facing any roadblocks to continuing forward with its ongoing effort to shrink the size of its balance sheet – Reuters. (Why you should care – the data implies the financial system shouldn’t face any near-term liquidity issues)
Federal Reserve Bank of Chicago President Austan Goolsbee said that over the next year or so, interest rates should end up “a fair bit lower than they are today”; he believes that inflation growth is on a sustainable path below the central bank’s 2% target – Chicago Fed. (Why you should care – Goolsbee will be a voting member of the Federal Open Market Committee next year)
Pacific Investment Management Co. (PIMCO) thinks U.S. government bonds are an increasingly attractive investment following the recent surge in yields and the prospect of more Federal Reserve interest-rate cuts – Bloomberg. (Why you should care – the commentary indicates the fixed-income asset manager is likely buying up U.S. Treasurys)
Economic Calendar:
Japan – au Jibun Bank Japan Manufacturing, Services, Composite PMI (Preliminary) for November
Eurozone – HCOB Eurozone Bank Manufacturing, Services, Composite PMI (Preliminary) for November (4 a.m.)
U.K. – S&P Global U.K. Manufacturing, Services, Composite PMI (Preliminary) for November (4:30 a.m.)
ECB’s Lagarde (President) Speaks (4:30 a.m.)
ECB’s de Guindos (Vice President) Speaks (4:40 a.m.)
U.S. – S&P Global U.S. Manufacturing, Services, Composite PMI (Preliminary) for November (9:45 a.m.)
ECB’s Schnabel (Board Member) Speaks (11:45 a.m.)
U.S. - Baker Hughes Rig Count (1 p.m.)
U.S. - CFTC’s Commitment of Traders Report (3:30 p.m.)
Fed Releases Balance Sheet Updates on Commercial Banks (4:15 p.m.)