Cheapest small-cap stocks in 20 years shows rally can keep going

A sharp rally in US small-cap stocks may have further to go, according to strategists.

Historical patterns spanning four decades indicate the Russell 2000 Index’s spike augurs more gains in the month ahead, according to Sundial Capital Research Inc. Small caps are trading at the biggest discount to large-company stocks in about two decades, suggesting they are inexpensive on a relative basis, Bank of America Corp. said.

Investors have the “best valuation entry point for small caps since March,” Bank of America strategists led by Jill Carey Hall wrote in a note Thursday.

The Russell 2000 has advanced more than 12% since a recent low on September 23 — almost twice as much as the tech-heavy Nasdaq 100 — a pattern that suggests many investors remain optimistic about the economic recovery and the odds of further spending on pandemic relief.

The Russell 2000 rose at least 10% over a 10-day stretch some 20 times in the past 40 years, and never showed a loss during the next month, according to Jason Goepfert of Sundial. It also tended to reward investors in the subsequent three months, he said.

Bank of America’s analysis shows that small caps are trading at a 26% discount to large peers, the widest in about 20 years, and are similarly cheap compared with mid caps.

The iShares Russell 2000 exchange-traded fund received $1 billion on Wednesday, the most since July. A ratio of the Russell 2000 versus the Nasdaq 100 is near its lowest levels since 2000 but may be breaking out, Bloomberg macro strategist Cameron Crise noted recently.

The possibility of a Democratic sweep of the November 3 election could also bolster small caps, since nominee Joe Biden is expected to push through huge stimulus. In contrast, big technology firms could be hit with increased regulation to curb their dominance.

Cantor Fitzgerald LP said expected corporate tax increases under a Democratic administration may have less of an impact on smaller companies. Eric Johnston, head of equity derivatives and cross asset, recommended November call options on the iShares Russell 2000 ETF to bet on market upside.

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