US small-cap stocks have historically outperformed their counterparts, US large-cap stocks, under two scenarios. First, during periods of rising US interest rate environment. Why? Rising US yields typically occur during the start of an economic expansion or when the economy begins to recover. Second, when the Federal Reserve (FED) signals that they will no longer decrease rates to stimulate the economy.
It is also believed that many contrarian type investors also begin to buy small-cap stocks when the broad market have suffered a setback and specifically small-cap stocks have declined sharply from its highs. During this timeframe investor optimism is at an extreme low and many illiquid and lower quality names have been washed out as a result of a selling exhaustion. When the sentiment begins to improve many of the mid-cap, small-cap and micro-cap stocks begin to again grow and appreciate faster than the large-cap names.
The last period when the mid-cap, small-cap, and micro-cap stocks dramatically outperformed the large-cap markets were during Feb 2016-Dec 2018. For instance, S&P 500 Index (SPX) rallied 62.47% from its 2016 low to its 2018 high. During the same time frame, S&P 400 Mid-cap Index (MID) returned 68.96%, S&P 600 Small-cap Index (SML) gained 89.22%, and iShares Micro-cap ETF (IWC) rallied 92.58%.
Although it is difficult to determine if this scenario will be repeated, as the larger-cap US equities market continue to trend higher this rally may begin to broaden to the laggards such as the mid-caps, small-caps and even micro-caps. Like a small boat in a sea, smaller-cap stocks can move faster and navigate with more precision than the larger-cap ocean liners.
Enclosed below are charts of the mid-cap, small-cap, and micro-cap indexes along with technical projections as well as risk levels.