Small-cap stocks have taken a back seat to large caps in recent years, but the relative drought is over. Or at least it’s faded in recent months, based on a set of exchange traded funds that represent a variety of US equity risk factors.

The shift in leadership is certainly conspicuous in the new year. Notably, three flavors of small-cap stocks (value, core and growth) are leading the field by a wide margin, based on 2021 returns through last week’s close (Jan. 15).

A few weeks could be noise, of course, but small caps also have an edge via ETF-based factor results since last year’s Mar. 23 market bottom, based on the broad market’s trough during the coronavirus crash. Since that point, small-cap growth, core and value have three of hte top-four spots for equity factor performance.

For a longer-run view, the next chart tracks the relative performance of small caps (IWB) vs. large caps (IWM) over the past 20 years. When the line is rising (falling), small caps are outperforming (underperforming) The recent revival in the fortunes of small caps is striking for the depth and rapidity of the shift.  

What’s driving the small-cap rally? A popular narrative is that smaller companies are poised to be the leading beneficiaries of a post-pandemic economic rebound.

The question, of course, is whether the recent small-cap edge is noise or the start of an extended bull run that favors shares in the lesser capitalization realm? No one knows, but for the moment the crowd is giving small-cap stocks a fresh look.

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To the extent that the bounce in small caps is drawing strength from macro optimism for the year ahead (and beyond), the US economy needs to pull out of its recent slowdown and deliver firmer growth. That’s a tall order at the moment, thanks to the latest post-holiday surge in coronavirus cases, deaths and hospitalizations. But with vaccines rolling out, the potential for relief is looking more plausible by the day.

There are hints that the deadly surge in the daily change in new US Covid-19 deaths has peaked. Coronavirus fatalities fell for a sixth day through yesterday (Jan. 18) after reaching a record high last week. It’s premature to declare victory, but for now the numbers are moving in the right direction.  

Meanwhile, the incoming Biden administration is reportedly set to focus on a new round of coronavirus relief. Janet Yellen, President-elect Biden’s pick for Treasury Secretary, is expected to tell the Senate Finance Committee today that the federal government must “act big” with more stimulus.

Embedded in the small-cap rally is the assumption that meaningful progress is near for reversing the surge in unemployed workers. The weekly sky-high jobless claims data is a critical metric to watch for deciding if there’s a basis for the optimism.

Measured by the small-cap rally of late, optimism reigns supreme. All that’s need is supported economic data in the weeks and months ahead.

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