US small-cap stocks have raced ahead of their bigger peers in 2021. Experts say a number of factors could send them higher.

Small-cap stocks have outshined their bigger peers so far this year on Wall Street.

  • US small-cap stocks suffered in the first COVID wave but are now powering ahead.
  • The Russell 2000 index has jumped more than 10% in 2021 already.
  • A number of factors, from stimulus to vaccines to tech regulation, could push them higher.

The stock market recovery from the coronavirus crash in the spring of 2020 was all about the biggest US names: Amazon, Apple, Facebook, Google, and Netflix.

But the smaller, more unloved parts of the stock market come roaring back in the autumn and winter, and their momentum has continued in 2021. The Russell 2000 index of small-capitalization stocks has jumped 1.5%, for example. 

Small-caps have had “a tremendous rebound,” says James Gowen, chief investment officer at Spouting Rock Asset Management in Pennsylvania. He said earnings expectations have “really started to come up.”

So, can this tremendous rebound continue? There are clouds on the horizon: COVID-19 infections and deaths are still rising around the world, while vaccine rollouts have not always gone smoothly.

But investors are broadly optimistic that a number of factors can continue to support smaller US shares.

Joe Biden stimulus set to boost smaller shares

Small-caps crashed in March when coronavirus first took hold around the world: the Russell 2000 plunged more than 40% from the middle of February to the middle of March.

Bigger companies were less badly affected – the S&P 500 fell around 33% in the same period – and then bounced back more sharply as the widespread switch to home-working boosted the tech giants.

But things started to shift in November, when positive vaccine trial results led to hopes that the COVID-19 pandemic could soon be curtailed. Suddenly, smaller firms – whose stocks were cheaper – started to look like they could deliver higher returns in 2021 as the economy recovered.

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In recent weeks, the victory of Democrats in the Georgia runoff elections has further boosted small-caps, paving the way for Joe Biden to unveil a $1.9 trillion stimulus package on Thursday.

This is in large part because the Russell 2000 index of small-caps is “more cyclically biased” than many of the bigger indexes, says Philip Lawlor, head of global investment research at FTSE Russell, which runs the 2000. That is, its stocks are more closely linked to the health of the economy.

As of January 8, energy stocks in the Russell 2000 were up a startling 24% in 2021, while basic materials were 8.2% higher and utilities and industrials were up around 6% each. That trend is likely to have continued last week.

Gowen says rising growth and inflation, which has been pushing up bond yields, would be helpful to the financial firms that make up around 15% of the index, according to Siblis research.

Analysts at BCA Research said in a note: “More stimulus, a lower dollar and higher inflation breakeven rates will help industrials, materials and financials and hurt tech … These sectoral views favor small-cap equities and value stocks.”

Lawlor says 2021 could bring a “double whammy” for small-cap shares if the Democrats choose to take a tougher line on the big tech firms.

Investors look through short-term gloom

Yet it won’t all be plain sailing. The US, like many countries around the world, is suffering a sharp rise in coronavirus cases. States have introduced new restrictions, hitting businesses.

On Thursday, figures showed new jobless claims jumped to close to 1 million in the previous week, the biggest rise since March.

Unveiling his stimulus plan in Wilmington, Delaware, on Thursday, Biden said: “A crisis of deep human suffering is in plain sight, and there’s no time to waste.”

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Some scarring on the economy could hit smaller US firms as unemployment rises. And a few analysts are worried that social distancing measures and caution may stick around longer than people think, as vaccines are unlikely to completely eradicate COVID-19.

Yet markets are hopeful about smaller companies’ future earnings, which is their focus. “They’re much more concerned about what’s going to be happening in 6 months, 9 months, 12 months’ time,” says Lawler.

“What I think people are anticipating is the notion that there’s going to come a time in 2021 when we start looking at the up-slope of growth and the recovery. And, weighing up the scale of pent-up demand, that could be underestimating the size of the recovery.”

Small-caps could benefit from innovation

Gowen argues that the Russell 2000 index is “not just value” stocks. It can also profit from structural shifts in the economy, he says.

The pandemic battered many companies, Gowen says. Yet it was also “an incredible tailwind and benefit to a number of businesses where they were well-positioned to take advantage of trends that were already in place but accelerated by COVID.”

Healthcare and information technology, which make up around 21% and 14% of the Russell 2000 respectively, are key areas, Gowen says.”A great example might be consumer-directed healthcare [and] areas like telemedicine.”

He also cites cloud computing and video conferencing, given that service sector employees “all work at home now.”

Whatever the opportunities for innovative companies, policymakers – from the President-elect to Federal Reserve officials – this week made it clear that they would keep up economic support.

“The economy is far from our goals,” Fed chair Jerome Powell said on Thursday. “We are strongly committed … to using our monetary policy tools until the job is well and truly done.”

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