IWL - IWM: Small-Caps Likely To Join The Party In A Big Way

2023-07-03 13:43:48 ET

Summary

• Small-cap stocks are expected to join the current bull market rally, with the Russell 2000 ETF seen as a good way to capture incremental outperformance that may be missed by investing solely in the S&P 500.
• The Russell 2000 ETF provides diversified exposure to small caps, mitigating risks such as liquidity risks that are often associated with owning small cap stocks with thinner ownership.
• Despite the higher risk inherent in small caps, they also have a higher potential for growth, especially during bull markets when they tend to outperform the S&P 500.

Don't look for the needle in the haystack, just buy the haystack. - John C. Bogle

Do you remember when the lockdowns ended? The first time you started going to places with crowds and returning to large social gatherings was a bit anxiety-ridden. Some of life's best events were foregone for periods longer than we imagined possible. And when people first started gathering, it may have been a bit timid at first, like the quaint garden party pictured above.

Small caps have been lagging behind the performance of their more prominent major index peers, but they may be getting ready to join the party in a big way. The current bull market is in its garden party stage, but as the metaphorical night goes on, things will inevitably get more raucous, and the small caps will likely join and perhaps lead the continuation of the rally we've had in 1H23.

Of course, as the liquor got flowing and people started hearing about the parties, people let loose, and before you knew it, parties became the same old ragers we remembered from before the pandemic; it might have just taken a little longer. I think it's very similar to the sentiment in the market right now.

The party is about to start heating up based on the Fed's comments, economic indicators, sentiment, positioning, and simple bull market momentum. I think adding small caps via the Russell 2000 ETF ( IWM ) can help you capture incremental outperformance that you might miss if you're just invested in the S&P 500 ( SP500 ).

On a monthly basis, the relative outperformance leadership has changed. You might be surprised that over the last month, the rally wasn't led by Technology and the Nasdaq ( QQQ ) but was led by Dow ( DIA ) and the Russell 2000. On a five-day basis, IWM is now slightly leading. I think it's a great time to get exposure.

The party's getting rowdier, and gains are broadening. There is a major advantage of using this ETF to get diversified exposure to small caps as well. It's a great vehicle and removes some of the most unpleasant risks when owning small-cap stocks with thinner ownership, like liquidity risk.

Being Long IWM Complements My Recent Analysis

I have written extensively lately on the following themes, and they all are supportive of this bullish call I am currently making on Small Caps via the Russell 2000 ETF ((IWM)):

• The Fed tightening cycle is over, or nearly over , and gains from AI have been more fundamental than frustrated bears would like to admit, so it is likely this rally has legs .
• The gain in large-cap Technology like Microsoft , Apple , and others has largely been due to enthusiasm over Artificial Intelligence. Still, these firms will also continue to do well if we avoid recession.
• The Fed has given the all-clear to the market, permitting the current rally to continue, or at least as long as the downward trajectory of inflation continues.
• Official projections from the June SEP have the economy avoiding a recession, and the Fed is increasingly taking more dovish than hawkish actions.
• Indicators are showing resilience in the economy and the potential that an expansion may even be starting. If we are early cycle rather than late cycle, as many market participants still think, then small caps should soar.
• Housing market strength has been impressive, particularly in the face of high rates. Consumer confidence recently hit a 17-month high .

Small caps are, in some ways, the heartbeat of the American economy. The bulk of Americans are employed at smaller businesses, and while the Megacap tech titans get a lot of visibility, America runs on small businesses.

Typically, small-cap stocks evade the radar of many investors because they will ALWAYS have more risk than their large and mega-cap peers. One way to mitigate this risk is through diversification, and IWM achieves this as an ETF splendidly.

Two thousand companies is a lot of diversification, even if the companies are at a higher risk stage of the corporate lifecycle than blue chips. The risk of failure is considerably higher for small caps at the level of any individual firm, which can be mitigated. Still, when economic times get tough, there can be a lot of carnage in their ranks, as has been witnessed several times since COVID.

So tread carefully. Still, I like to think of small caps as a perfect complement to a portfolio anchored in more stalwart blue chips. You can use it as the riskier element in a barbell; even if you are a passive investor who sticks to index-level ETFs, the Russell can result in some serious alpha if it's integrated properly into your strategy.

On the flip side, though, small caps also have higher potential for growth (it's easier to double revenue when you're small than when you're huge), and the best time to own them is bull markets when they tend to outperform the S&P 500, like in the last bull market we experienced in the wake of COVID. As you can see, though, other than the inherent risk, there are a lot of benefits on the ETF Grade scorecard for IWM.

• You have high liquidity of the vehicle, which might not be the case when owning individual names.
• Using the last bull market as an example, you can add to your alpha by having an allocation to the Russell and the S&P 500 rather than just the S&P.
• For conservative investors who want to juice their returns without investing the time and facing the risk of owning individual small-cap names, the IWM is a really great tool.
• Not only can you add diversification, given the sheer number of companies you are getting exposure to, but there is a lot of great evidence about the long-term benefits of owning small caps.
• There are also opportunities for massive price moves due to the relative lack of analyst coverage; this inefficiency can be an opportunity when high-beta is working in the market, as it tends to during bull markets.
• I will also be providing some great individual small-cap names that have a positive risk/reward and valuation in the coming days and weeks.

Because of the higher risk inherent in small-caps, if you're not going to do the nitty gritty and try to do informed stock picking, I personally feel that the best way to get exposure is to use broad tools like the IWM ETF. For more risk-averse investors, you can also try more specialized ETFs like the ones below.

The earlier in the stage of life a business is, the more likely it is to fail without knowing anything else about it, and one way to mitigate the potential downside in a downturn is to limit your exposure to the top 200 companies with The top 200 Russell ETF ( IWL ). You can also get exposure to Russell Growth companies with ( IWF ).

This is a great example of how the ETF revolution makes interesting ways to slice and dice exposures available to individual investors. You'll notice the growth component has led, and the top 200 were second, with the broad IWM being last. However, as compared to the other indices, I think recent developments suggest the rally in small caps is broadening out across the entire Russell 2000 Index.

You'll see above that over the last month of performance, the YTD component has largely reversed, and the IWM is beating its more specialized components. While it's not good to own low-quality stocks over the long term, particularly if they are overvalued, in the short term during bull markets, a rising tide lifts all boats, and sometimes the gains in even the lower quality corners of the index can propel it higher than purely fundamental methods can justify.

You can see that above, on a 5-day basis, this reversal is even more pronounced. I think there's evidence to suggest that this might be the beginning of a notable bull market and that small-cap relative outperformance is more likely than usual. This could be a very helpful piece of information for active managers who missed out on the rally of the "Magnificent Seven."

So, insulating yourself against the inevitable failure of many individual companies owning the ETF allows you to get exposure to that enticing small-cap growth premium that can really pay as the "market party" starts to heat up from a tame garden party to a raging kegger.

When the market heats up, though, it's probably best to own the wider IWM than more specialized alternatives unless they comport with your specific strategy better.

Recent Leadership is Suggesting a Bull Market is Underway

So, I've provided some of the economic rationale and historical analysis to show why you want to own IWM in a bull market. But now I want to dive into this ETF specifically and why I think short-term and medium-term upside and outperformance are likely.

Remember, outperformance is not always where you think it will be. I recommended Ford Motor Company ( F ) on May 22nd, and it is up nearly 30% and has outperformed the S&P 500 ((SP500)) by roughly 2,300 basis points over that period!

There weren't a lot of people who were as enthusiastic about Ford in late May, but the very fact that this firm has outperformed so much should give you some idea of where we are in the economic cycle. Ford has not been alone; you may not have realized that Consumer Discretionary as a sector outperformed Technology over the last month. This doesn't seem too recessionary to me!

Risks and Where I Could Be Wrong

The Russell 2000 is the riskiest of the major indices because of the composition of smaller market cap companies. More can go wrong at these companies, and they rarely have the balance sheet strength to absorb the risk that larger companies do. So there are plenty of idiosyncratic risks:

• Small caps tend to have higher volatility at the individual stock level and often at the index level as well.
• There is a lot less information on small-cap stocks, which can lead to higher chances of fraud, theft, or operational failure.
• Small caps often have business models that are less proven and more subject to being derailed by capable competitors or new entrants.
• The Russell 2000 can be more economically sensitive than the other indices, and many of the businesses are also more closely tied to regional banks.

Anything that derails my thesis that a bull market has begun could lead to a vicious reversion of the gains small caps have had in the last month. Any of the following risks becoming more severe could be problematic for my thesis:

• Escalation in Ukraine or Taiwan.
• Fed Policy Error.
• Banking Issues Worsen.
• Return of Inflation.
• CRE meltdown.
• Write-downs of Private Assets.

So, there are plenty of risks that could derail my bullish call on the Russell 2000. Still, absent the worsening of the above issues or an unforeseen black swan risk creeping up, I think there will be more gains in the short and medium term that could very likely eclipse those of other indices.

Conclusion

So, as you can see, there are many risks that can derail small caps, and sometimes the gauntlet of risks is most cruel to this relatively vulnerable index. So, I never advise being dramatically overweight the Russell 2000 unless that's core to your strategy. However, being overweight to complement an S&P 500 position is a relatively safe way to add incremental outperformance during a bull market.

Several items give me confidence in my bullish call:

My former colleague, Mark Newton, who is the best Technical Analyst I've ever come across, has brought up a very important point. Over the last month, despite public perceptions of a one-trick rally, Industrials, Materials, and Discretionary all outperformed Technology.

I believe this increasing participation likely continues in the next month or so; at least, I suspect small caps will start to get to the top of the performance list as well. Market pullbacks recently have been shallow and suggest a buy-the-dip regime may have returned.

The Seeking Alpha Quant Grades are a very valuable tool that can always give you additional confidence when they align with your thesis. I was at an independent research firm, and we had a lot of resources, and I've been very impressed at what Seeking Alpha is able to offer on a wide scale. One of their biggest achievements on the analytics side, in my humble opinion, is the great suite of democratized Quant tools they've assembled.

These aren't everything in markets, but it is always an essential lens that can help check confirmation bias and give you another perspective on stock or ETF other than your own thesis. It helps you size up strengths and weaknesses.

Overall, I think we are in the early stages of a bull market that never feels ebullient. It always feels like you stole it early in a bull market. I think using a reasoned and comprehensive approach to analyzing the data and recent price actions infers a bull market has begun. This bodes very well for the Russell 2000.

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