The iShares Core S&P Small-Cap ETF (NYSEArca: IJR) and the iShares Russell 2000 ETF (NYSEArca: IWM) are scuffling this year and investors are looking for catalysts that could lift smaller stocks.
Expansionary fiscal policies have fueled inflation expectations, which have in turn raised bets on a Federal Reserve interest rate hike and strengthened the U.S. dollar. Consequently, with a stronger U.S. dollar, large-cap stocks may underperform as many large exporters find it harder to sell goods to foreign markets.
However, the market’s enthusiasm for small-caps has recently waned in dramatic fashion prompting some traders to call for more downside for the group.
“The turn in the dollar, while not directly the cause of small cap underperformance, is indicative of a broader pattern: The “reflation trade” that began in mid-2016 has been struggling of late. One manifestation of this has been the recent pullback in credit, specifically high yield. This is important. Since 2000, monthly changes in high yield spreads have explained roughly 10-15% of small cap’s relative performance,” said BlackRock in a recent note.
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.
Adding to small-caps’ struggles are high valuations.
“Neither large nor small cap U.S. stocks are cheap, but small caps look particularly pricey. The Russell 2000 was already expensive last December; at nearly 48x trailing earnings it is even more so today,” said BlackRock.
A smart beta alternative to IJR and IWM is the Guggenheim S&P Smallcap 600 Pure Value ETF (NYSEArca: RZV), which has a heavily cyclical lineup. RZV targets companies that exhibit the value characteristic but focuses on the smaller companies taken from the S&P SmallCap 600 benchmark. Industrial, consumer discretionary and materials stocks combine for 57% of that ETF’s weight.
Another idea to consider is the the Schwab Fundamental U.S. Small Company ETF (NYSEArca: FNDA). FNDA, which launched in 2013, tracks the performance of the Russell Fundamental U.S. Small Company Index, which includes the bottom companies that weight below 87.5% from the Russell 3000 Index.
Tom Lydon’s clients owns shares of IWM.