After underperforming over the past few years, small capitalization stocks and related exchange traded funds are outpacing their larger peers.
Over the past three months, the iShares Core S&P Small-Cap ETF (NYSEArca: IJR), which follows the S&P SmallCap 600 Index, gained 6.6%. The Vanguard Small Cap ETF (NYSEArca: VB), which tracks the the CRSP US Small Cap Index, rose 6.2%. The iShares Russell 2000 ETF (NYSEArca: IWM), which reflects the benchmark Russell 2000 Index, increased 6.7%.
Meanwhile, the S&P MidCap 400 Index was up 5.7% and the S&P 500 Index was 4.4% higher over the past three months.
[related_stories]Supporting the recent move in the small-caps segment, the broad equities market has made a robust rally off its February lows and now expectations for future earnings are on the rise.
As the broad equities market pushes toward new highs, riskier assets like small-caps have been able to rally back much quicker. When the economy is doing well and the markets rally, we see sentiment for more nimble smaller companies improve and outperform those of their more languorous, larger peers.
Small-caps are also focused on the domestic economy and have less direct exposure to global geopolitical uncertainty and currency risks, as opposed to large-cap companies that have an international footprint, which may be affected by overseas risks and a strengthening U.S. dollar.
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Moreover, merger and acquisition activity can continue to pick up ahead, with larger companies seeking to expand by purchasing smaller businesses to complement or expand their markets. Larger firms may be more apt to engage in M&A activity now, especially with interest rates and financing costs near historical lows.
Despite rallying over 20% since its February lows, the benchmark Russell 2000 may have more room to run. The Russell 2000 is still about 3% off from its all-time high set in June of 2015. Moreover, for all the technical chart watchers out there, the index has formed a bullish inverse head and shoulders pattern after falling to a trough in the late summer months of 2015, decreasing below that previous trough to an even lower point in February 2016 and lastly dipping again in recent months but not as far as the second trough. Currently, IWM has broken above its resistance at the neckline of about $117.5 per share and trades at $120.8, but it still remains short of its $124.86 closing high.
Related: ETFs In 2016: Large Cap vs. Small Cap
In addition, the small-cap ETFs are still attractively priced relative to their larger counterparts.
For instance, IWM shows a 18.45 price-to-earnings and a 1.68 price-to-book, IJR has a 19.39 P/E and a 1.87 P/B, and VB comes with a 19.77 P/E and a 1.89 P/B. In Contrast, the Russell 1000 Index of large-caps is trading at a 18.64 P/E and a 2.52 P/B. Historically, the Russell 2000 has traded at an average 5% premium to the Russell 1000 Index since 1985, according to Bank of America Merrill Lynch data.