This month’s rally of the S&P 500 is inclusive, as opposed to previous months.
Analysts are paying attention to small cap stocks as well.
Jeff Jacobson, of 22V research believes that this is a good signal for smaller-cap stock. He argues they are in a great position to breakout and possibly outperform large-cap stocks.
Jacobson, in a MarketWatch article, notes that the main reason the market has broadened is the fact that it’s less focused on the mega-cap “Magnificent Seven” stocks. These have been underperforming since July.
“He says”
Only Meta Platforms out of the seven stocks included in Mag 7 has managed to surpass the highs reached during July, despite the S&P 500 continuing to break records.
The shift in the tech sector away from megacaps has allowed other sectors to grow, such as small caps.
Small caps could benefit from the earnings season
Jacobson identifies earnings season as a catalyst for growth in small-cap stocks.
Small-cap stocks, as measured by the iShares Russell 2000 ETF, (IWM), saw a strong rally in July when earnings season hit full-swing.
Jacobson recalls that between July 10th to July 30th we witnessed IWM rise by 9.44% while the tech stock declined by more than 9%.
A similar shift away from technology during the next earnings season, he believes, could benefit small cap stocks.
The financial sector, which represents nearly 20 percent of the Russell 2000 Index, is also key for this sector.
There is optimism about smaller financial institutions and banks following the lead of large banks, which have recently delivered solid earnings.
IWM will benefit from a boost if smaller financials are well received, as we have seen this summer.
Treasury yields indicate strength in small cap stocks
Jacobson highlights also the positive impact that rising Treasury yields have on small-cap stock.
Jacobson says that while higher bond yields can initially cause concern about the impact on smaller firms, recent changes in the market actually support small-cap growth.
The increase in the 10-year Treasury yields from 3.6% to 4% reflects an economic contraction risk that is reduced, favoring small-cap stock’s cyclical character.
Jacobson says that the rising yields due to strong economic data is a good reason for investing in cyclical small cap stocks.
He says that although there might be an immediate knee-jerk response to sell small-caps when Treasury yields increase, any drop in Treasury yields can work in the investors’ favor–especially if economic data remain strong.
Seasonal and technical trends are aligned
Jacobson points out technical factors which could also support the small cap.
Russell 2000 is still above the 200-day moving mean despite market volatility.
Small caps remained resilient even during the early August sell-off.
He says that “IWM has fallen only 2% from the resistance level of about 225 which was the peak in September and July.”
Jacobson believes that a break above the resistance level is increasingly probable, given the market momentum in the last months of the calendar year and its historical performance.
Seasonal factors, as well as technical factors, favor the small cap.
In the last five years, the Russell 2000 has had the most positive performance in November and December. This adds to the overall optimism for this sector.
Options for trading small caps
Jacobson uses options in this situation to maximize the breakout potential.
He proposes selling IWM puts in December at a strike price of 205 to fund the purchase IWM calls for December at 230.
He notes that “on the sharp rally of July, we witnessed upside call volatility explosion higher into the movement.”
Jacobson, for this reason, prefers to buy calls directly rather than use an upward call spread. This is a way of positioning himself in anticipation of a possible strong rise in the small-cap stock market over the next few months.
The post This may be the right time to invest in small cap stocks. A strategist shows you how to trade it may change as new information becomes available.
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