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This ETF Will Tell You When Small-Cap Stocks Are Ready to Rally

Small-cap stocks have been lagging their large-cap brethren all year; keep an eye on this ETF for signs of a broader (healthier) rally.

Magnifying Glass

Small caps are dramatically underperforming year to date (YTD). That might just spell opportunity for investors that can pull their attention away from the gravitational pull of mega-cap tech stocks.

Consider this.

Through Friday, July 21, the Nasdaq is up 35.7% YTD.

The S&P 500 Index is up 18.6%.

Both have been helped, to varying degrees, by the strong performance of the mega-cap tech stocks, Microsoft (MSFT), Apple (APPL), Alphabet (GOOG), Amazon (AMZN), NVIDIA (NVDA) and Meta Platforms (META).

Those six stocks have a combined weight of around 24% in the S&P 500 and had a combined weight in the Nasdaq 100 of more than 50%, prompting a special reweighting of the index.

Meanwhile, the Russell 2000 Small Cap Index is up a mere 12%. And the S&P 600 SmallCap Index is up just 8.8%.

Move even further down the market cap curve and it gets worse. The Russell Microcap Index is up 4%.

What the?

I’ve discussed this relative performance in previous updates to subscribers of Cabot Small-Cap Confidential and Cabot Early Opportunities.

The high-level reason is simple – it’s because index weighting in the Nasdaq and S&P 500 grossly favors the aforementioned mega-cap stocks. Which are doing fantastically well this year.

But that doesn’t tell the entire story. To really understand what’s going on, and see what’s needed for small-cap stocks to catch up, we need to dig deeper.

The following performance graphs, courtesy of Yardeni Research, for the large and small-cap indices show at a glance what I’m talking about. Let’s start with large caps.


As you can see, when it comes to large caps, the performance has been entirely driven by technology (28% weight) and consumer discretionary (10% weight) stocks.

Now, small caps.


Looking at small-cap stocks, technology (14.6% weight) and consumer discretionary (13.7% weight) are also the largest performance contributors. But industrials (17.8% weight) and materials (5.6% weight) are outperforming too.

The “problem” is the relative performance and higher weight of large-cap tech and consumer discretionary is just that much more powerful. And for small-cap stocks, the heavy weighting and big underperformance of financials (15.7% weight) and, to a lesser degree, energy (4.3% weight), are holding the small-cap index back.

The takeaway here is that, yes, the dramatic outperformance of mega-cap tech stocks is driving the bulk of large-cap versus small-cap outperformance. But there are areas where other stocks are doing well too. It’s just that these sectors/stocks are living in the shadow cast by the mega-caps.

So, what do we do with this information?

Well, the bottom line is that for the emerging “bad breadth” bull market to transition into a healthy bull market we need to see more participation from underperforming sectors.

For large caps that means consumer staples, energy, financials, health care, and utilities. At the same time, we need tech and consumer discretionary to not give back too much of their YTD gains.

In small-cap land, yes, energy and financials need to get in gear. But, in my view, financials are really the key.

That’s because the small-cap financial sector is where all the community and regional banks live. And stating the obvious, it’s hard to see a healthy broad market rally take shape if investors and consumers don’t have confidence in the thousands of small banks that are scattered across the country supporting the economy.

At the end of the day if you want to watch one thing that could determine the health of the broad market (disclaimer: we all know there’s no single indicator of market health out there) keep an eye on the Invesco S&P Small Cap 600 Financial Sector ETF (PSCF).

Yes, I know it’s an obscure ETF that trades on such light volume that most brokers will only let you buy it using a limit order and not a market order!

But still, the underlying reasons behind PSCF’s performance (or lack thereof) mean a lot to this economy, and therefore the market.

Deposits in small domestic banks make up roughly a third of all deposits in the U.S.!

In fact, over the last month, we’ve seen the PSCF come up off its lows. I think that’s a good sign of improving broad market health, even if in the short term we see some bumpiness in the mega-caps that have driven YTD large-cap performance.

You can learn more about what I’m recommending for small-cap stocks, including a recent small-cap AI stock, by grabbing a subscription to Cabot Small-Cap Confidential today.

Tyler Laundon is chief analyst of the limited-subscription advisory, Cabot Small-Cap Confidential and grand slam advisory Cabot Early Opportunities. He has spent his entire career managing, consulting and analyzing start-up and small-cap companies. His hands-on experience has taught Tyler that the development of a superior business model is the biggest factor in determining a company’s long-term success. Accordingly, his research focuses on assessing the viability of management’s growth strategies, trends in addressable markets and achievement of major developmental milestones.