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New optimism lifts U.S. small-cap stocks Add to ...

Say hello to the new stock market darlings: Small-cap U.S. stocks, often eschewed by conservative investors for their turbulent ways, have emerged from the recent market volatility and hit new highs.

The Russell 2000 small-cap index has risen nearly 20 per cent this year, including a 7-per-cent rebound from its June dip, when stocks and most other investments recoiled from shifting perceptions of economic stimulus from the Federal Reserve Board.

By comparison, the large-cap S&P 500 is still slightly below its record high in mid-May and trails the year-to-date performance of the Russell 2000 by about four percentage points.

The rally comes as a surprise, given many of the concerns about the health of the U.S. economy and corporate profits earlier in the year and the corresponding focus on large, dividend-yielding stocks as a way to play it safe.

The stocks of smaller companies tend to be tied to the domestic economy and come with smaller dividend yields. With optimism on the economy returning, but dividends falling out of favour because of concerns that the Federal Reserve will wind down its stimulus program earlier than expected, small caps are nicely positioned.

The question is whether investors should chase them. While it is rarely a good strategy to hop on any bandwagon, the rally among small caps is rooted in realistic optimism rather than unsustainable hype.

One point in their favour is that expectations for small-cap earnings growth for the current year are well above the S&P 500 – at 30 per cent, versus just 9 per cent for the large-cap index – yet valuations don’t reflect this difference.

The price-to-earnings ratio for the Russell 2000 is about 17, or one point above the S&P 500.

The other is that the U.S. economy is one of the few bright spots in the world, with a recovering housing market, improving employment numbers and positive economic growth striking a contrast to the situation in Europe and even emerging markets. Small caps – especially the regional banks that are geared toward a rising housing sector – remain an ideal play on this status.

But even if small-cap stocks are too wild and wooly for those investors who prefer the comfort of larger companies and household names, the rally is still good news: It provides an indicator that the bull market has legs.

Stephen Suttmeier, technical research analyst at Bank of America, views the strong small-cap performance as a bullish sign for the broader market because it shows that market breadth – or the number of stocks moving upward relative to those falling – is improving. This points to positive momentum.

“Leadership from small caps suggests that the market rally is broad-based and not just driven by a select group of mega-cap stocks that dominate a capitalization weighted index such as the S&P 500,” he said in a note.

As an investment, small-caps look attractive. But as a bull-market indicator, they look just as good.

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