Few investments have been more frustrating than small caps in 2017. After a huge rally immediately following the U.S. election last November, the group weighed on the broad market this year-that is until September rolled around. Per Ryan Detrick, Senior Market Strategist, “Small caps were down for the year as of August 21; now they are up more than 11% —just behind the 13% gain for the S&P 500 Index. Although this was a popular trade this year, it also will go down as one of the more frustrating, as it took so long to get moving.”
To put things in perspective, on August 21, the Russell 2000 Index closed down 0.02% for the year versus the S&P 500 that closed up 8.47%. Small caps then closed higher 24 out of the next 32 days and made 13 new highs during a 19-day stretch, including eight in a row. So what happened? Many of the so-called “Trump trades” started to work in September, as hopes over tax reform started to heat up, as we discussed in our Weekly Market Commentary: “Markets Buying Into Tax Reform.” Remember, small caps pay a higher tax rate than large caps, so any potential tax reform would benefit this group significantly.
As we discussed in our Midyear Outlook: A Shift in Market Control, although small caps had lagged by a wide margin in the first part of this year, we expected an eventual move higher from the group and that has now happened. This leads to the next question: Can the strength continue? We think so.
The Russell 2000 has been trading in an upward sloping channel since to the early 1990s, as you can see below. The top trendline slowed all rallies and capped small caps earlier this year. The good news is small caps have officially broken above this trendline, suggesting that continued strength and a continuation of the bull market is likely.
Last, small caps relative to large caps had a sharp breakout as well. As the next chart shows, small caps had been underperforming large caps all year, until the recent surge higher. This momentum is yet another technical indicator that small caps could continue to provide alpha as we move into 2018.