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Building the Case for Small Caps

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Building the Case for Small Caps

Small cap stocks, as represented by the Russell 2000, have lagged large caps so far this year and remain well below the record level set last August, even as the S&P 500 and the Dow reached new highs. But conditions may be falling into place that will allow small caps to shine again.

A strong dollar should help, as small caps are typically focused more on domestic markets than their large cap counterparts. Roughly 15% of the sales of Russell 2000 companies comes from overseas; whereas for the S&P 500 that number is more than 40%. The recent Fed decision to remain on “pause” in terms of lifting interest rates is another positive, as it helps reduce the cost of borrowing.

Small caps actually did outperform for much of last year, benefiting from concerns over global trade, among other factors. But going into the end of the year they began to fall behind as concerns grew over a slowdown, and that trend has continued into 2019 (though they rallied strongly in 1Q along with the rest of the market). What could turn this around? Recent indications that the domestic economy may be stronger than believed should help. The Commerce Department reported 1Q GDP growth of 3.2%, well above expectations. Job growth also remains robust, which should support spending.

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While the small cap segment has not historically been the strongest of late cycle performers, there is some evidence that we might not be as deep in the economic cycle as was previously thought. With the Fed at neutral and, for all its fits and starts, at least some possibility of the trade dispute with China finally finding a resolution, the economy may have room for continued growth. That should be supportive of small caps, too.

First quarter earnings have seen a slowdown year-over-year but were generally stronger than expected. Expectations for the rest of the year are for continued modest growth. Small cap companies generally have higher growth rates compared to large and have a chance to again outperform in this economic environment, particularly if the dollar stays strong. Should U.S. economic growth continue to strengthen, that will be a positive as well.

But the case for small caps is not really about quarter-to-quarter returns. It’s a long view focused on participating in a vibrant part of the market that offers innovation and growth, and value, too. For investors building a diversified portfolio, it’s a category that deserves close consideration, and one that we’ve looked to capture in a unique way, through the multi-factor IQ Chaikin U.S. Small Cap ETF (CSML). Stock selection is done using the Chaikin Power Gauge, a 20-factor model that combines value, growth, technical, and sentiment indicators to identify companies that are expected to outperform their peers over time. It typically holds 200-350 stocks that carry the highest Power Gauge ratings. Should small caps start to see the rebound that all the factors above seem to point to, it could be a compelling approach for investors interested in looking beyond various overly broad small cap approaches or potentially over-concentrated sector funds.

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