The recent rally in the S&P 500, which hit its 45th record close of 2024, is more inclusive than in previous months.
While banks and financials have led this broader market rise, small caps are also catching the attention of analysts.
Jeff Jacobson of 22V Research believes this is a strong signal for small-cap stocks, which he argues are well-positioned to break out and potentially outperform larger stocks.
According to a MarketWatch report, Jacobson notes that a key reason for the market’s broadening lies in the reduced focus on the “Magnificent 7” mega-cap stocks, which have underperformed since July.
He says,
Of the 7 stocks in the Mag 7, only Meta Platforms has been able to eclipse the July highs, even though the S&P 500 has continued to set new records.
This shift away from the dominance of mega-cap tech has opened the door for other sectors, including small caps, to gain momentum.
Earnings season could boost small caps
Jacobson points to another catalyst for small-cap growth: earnings season.
In July, when earnings season was in full swing, small-cap stocks—as measured by the iShares Russell 2000 ETF (IWM)—saw a significant rally.
“Between July 10th and July 30th, we saw IWM rally 9.44%, while tech stocks declined by over 9%,” Jacobson recalls.
He believes a similar rotation away from tech during the upcoming earnings season could again benefit small caps.
Moreover, financials, which represent nearly 20% of the Russell 2000 index, are key to this sector’s performance.
As large-cap banks have delivered strong earnings recently, there is optimism that smaller banks and financial companies will follow suit.
If smaller financials deliver well-received earnings, it will provide a significant boost to IWM, just like we saw this summer.
Treasury yields signal strength for small caps
Jacobson also highlights the positive impact of rising Treasury yields on small-cap stocks.
While higher yields typically create initial concerns about a headwind for smaller companies, Jacobson argues that recent moves in the bond market are actually supportive of small-cap growth.
The rise in 10-year Treasury yields, from around 3.6% to over 4%, reflects a reduced risk of economic contraction, which favors the cyclical nature of small-cap stocks.
“Rising yields because of strong economic data are supportive for buying cyclical small caps,” Jacobson explains.
He adds that while there may be an initial knee-jerk reaction to sell small caps when yields rise, any pullback in Treasury yields could work in their favor—particularly if the economic data remains strong.
Technical and seasonal trends align
Jacobson also points to technical factors that could further support small caps.
Despite market volatility, the Russell 2000 has held above its 200-day moving average since December.
Even during the sell-off in early August, small caps managed to stay resilient.
“IWM is now only about 2% below the well-defined resistance level of 225, which were the highs in July and September,” he says.
Given the broader market’s momentum and historical performance during the final months of the year, Jacobson sees a breakout above this resistance level as increasingly likely.
In addition to technicals, seasonal factors also favor small caps.
Historically, November and December have been the best-performing months for the Russell 2000 over the past five years, further adding to the optimism surrounding the sector.
Strategic options for small-cap trades
Given this favorable set-up, Jacobson prefers using options to capitalize on the potential for a breakout.
He suggests selling IWM December puts at a 205 strike price to finance the purchase of IWM December calls at a 230 strike price.
“On the sharp rally in July, we saw upside call volatility explode higher into the move,” he notes.
For this reason, Jacobson prefers to own calls outright rather than using an upside call spread, positioning for a potentially strong rally in small-cap stocks over the coming months.
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