Fed Chairman Jay Powell’s recent comments assuring markets that the Fed was in no rush to raise rates appear to be having a calming effect on markets – and one particular group of stocks is set to take full advantage of the opportunity.

Today, we’re going to break the market down and focus on that specific group of stocks – a former leader-turned-laggard that is now turning into a Relative Strength leader.

These are just the kind of stocks Relative Strength investors are always on the lookout for…

The Fed’s decision to keep rates lower for longer means cheaper money, helping to fuel additional economic growth. This is the perfect backdrop for small-cap stocks to flourish because smaller companies tend to be more sensitive to changes in the economy than their large-cap cousins. 

That can lead to relative outperformance for small-caps… and where there’s relative outperformance, there is absolute outperformance.

The last time relative strength turned in favor of small-caps, they scorched the return of the S&P, returning 93.55% compared to 60.55% for the index (between the March 2020 COVID lows and year-end 2020).

Small-Caps (IWM) vs. Large-Caps S&P 500 (SPX)

But for the last seven months, small-cap stocks have grinded sideways.

And many investors have lost both patience and interest. But that could turn out to be a costly mistake. More on that in a minute…

But first, what are small-cap stocks?

Small-caps is short for small market capitalization, which is equal to a company’s share price times the number of shares outstanding. A company is classified as having a small market capitalization when that market cap falls between roughly $300 million and $2 billion.

Stocks classified by market capitalization are generally divided as follows:

Why does the market cap matter?

The smaller the company, the more perceived risk of loss of investor capital if things don’t go well. However, with risk comes potential rewards, as these small-cap companies can offer tremendous upside potential if they’re successful. It’s what draws investors in.

Larger, more seasoned, and stable companies are often considered less risky when compared to investing in a smaller company. And although they too offer upside potential, it is not unusual for small-cap stocks to rise much more dramatically during their growth cycles.

As long as the economy and markets are perceived as strong, investors are more willing to risk capital with investment in smaller, less proven companies.

But, when investors get spooked, the first stocks investors sell are the smaller, more volatile ones, choosing to keep the well-established companies that are more likely to weather the storm and save investors from large losses.

Which brings us back to today…

Take a look at this price chart of small-cap stocks (IWM). IWM is an ETF designed to track the performance of the small-cap index.

See the 225 on the price chart? It is an important level for IWM. There is a lot of price history there. It has acted as both support and resistance – a process called polarity.

Investors have been looking for a decisive move above 225. If prices can remain above this price – or even better, continue to rise – it will be a very bullish sign for stocks and small-caps in particular.

Unfortunately, most retail investors have been trained by the media to only watch big stocks like Amazon, Google, Tesla, and Microsoft – the biggest of the big… 

They’ve become complacent and lost sight of some very important shifts taking place right under their own noses. 

Of course, Wall Street likes it that way… if investors like you don’t spot what they’re up to, they keep more of the profits for themselves.

But not this time! Because you’re about to see proof of what Wall Street is up to…

You see, while investors continue to plow money into overpriced large-cap stocks, like the ones mentioned above, Wall Street traders are very stealthily buying up small-cap growth stocks.

Just look at this Relative Strength chart comparing the price change of small-caps to large-caps. It tells you everything you need to know about what some of the world’s largest investors are up to.

Take a look at the far right of the chart. It’s once again reversing up – indicating someone out there is buying up a lot of small-cap stocks.

This next chart looks at the past three months. The ratio was moving down, warning investors that small-cap stocks were weak compared to the large-cap stock alternatives…

But take a look at how the relationship swiftly changed in mid-August:

Like I said earlier: Where there is relative outperformance, there is absolute outperformance. 

Here’s the proof. Look at what’s happened over the last 10 days: The IWM has more than DOUBLED the return of the S&P 500.

Not only is this an important short-term development for traders looking for the next one-off trade, but the implications for the broader market cannot be understated.

If small-cap stocks – the riskier of the group – can break out like this after a seven-month consolidation, it means institutions, hedge funds, and mutual funds are back in “risk-on” mode.

That’s not bearish. That is bullish for small-cap stocks and for stocks in general.

If these smaller names continue to show strength, it’s hard to believe we’re in an environment where the rest of the stock market isn’t also doing well.

What does that mean for investors?

Well, investors whose portfolios have been lean in small-caps may want to evaluate their current allocation and decide if a higher weighting to stocks and small-caps makes sense for their portfolio…

Stay tuned for more… until then, invest wisely.

 

 

PS: We know it’s hard to make sense of all the headlines about the markets. It’s enough to make any investor feel anxious about their portfolios. But our clients at Rowe Wealth Management feel differently because our Relative Strength models are built to withstand volatility.

We have investment strategies to succeed in any market condition. We seek out what is working, and avoid what isn’t working. And we adapt to the market’s ever-changing nature so you don’t need to worry.

We understand investing can be stressful and difficult, so if you want to talk about how we make it easier, give us a call. We’re opening our doors to new investors who have portfolios valued over $500,000. If you’d like to schedule a free 1-hour consultation to review your portfolio, click here.