Lately, there has been a lot of talk about small-cap stocks breaking out of their recent ranges and catching up with their large-cap brethren. Do you think we are seeing a catch-up trade for small businesses? Yes, but you need to focus on the right areas to get the most out of your small investment. The Fed has begun to shift from a hawkish stance on monetary policy to a more dovish stance (supporting more accommodative policy), which has historically been a driver for small-cap stocks. Large stocks. Large-cap stocks often issue corporate bonds to finance their operations, while small-cap stocks typically rely on bank loans that fluctuate in response to changes in interest rates. Looking at the first chart of the Weekly Small Cap iShares Russell 2000 ETF (IWM), we see that a breakout is occurring at $202 from the sideways range that has enveloped us for nearly two years. Is there a chance of a breakout of resistance? And should I consider allocating exposure to this basket of 2000 small-cap stocks? I think a breakout should happen, but for two reasons I don’t think we should increase our exposure to the Russell 2000. The first is technical and the second is fundamental. First, if you look at the weekly relative rotation graph for IWM and the benchmark S&P 500, you’ll see that small cap stocks are gaining relative momentum and strength compared to the S&P in his December and his January, moving “upwards.” You can see that it’s trying its best to rotate. All was well until mid-February, when the wheels fell off. Ideally, the rotation would progress to the top right green quadrant, indicating outperformance compared to the S&P 500. However, it was rejected as the breakout from the $202 level has not yet occurred on the weekly chart. Fundamentally speaking, should we support this index breaking out, or if it doesn’t, should we be concerned about the fate of the bulls in the broader market? Again, the answer is no. I think. The index contains a significant number of fundamentally unsound companies. Choosing the Right Small-Cap Stock I used his Ycharts data to take a closer look at all the companies in the Russell 2000. And below are some statistics I found. 43% of the Russell 2000 has a negative trailing 12-month EPS, compared to 6% of the S&P 500. 8.36% of the Russell 2000 has a debt-to-asset ratio of 60% or higher, compared to 6% of the S&P 500. The value is 1.79%. Additionally, a significant number of small-cap stocks have floating rate debt that will be refinanced over the next five years. If the Fed cannot lower interest rates, these companies will be forced to refinance at higher rates. Many S&P 500 companies carry fixed-rate debt. Again, my answer is no. I don’t want fundamentally compromised companies that aren’t making profits coming to this rally. Because that would create an environment where “everything is going up” which is a sign of a bubble. I’m not saying we’ll eliminate small-cap stocks all together and continue to focus on large-cap stocks. We need to focus on fundamentally sound small-cap companies, and we can do that through the Pacer US Small Cap Cash Cows 100 ETF (CALF). This ETF includes small-cap companies with the highest free cash flow yields. If we look at the weekly chart of CALF, we see a completely different picture. The chart has already broken out of its two-year range and is currently holding near $48.50, looking to ride out the next high. An overview of how this ETF has performed since its inception shows that it has actually kept pace with the S&P 500, while significantly outperforming the Russell 2000 ETF. Digging deeper into the holdings of the CALF ETF, there is one name to keep an eye on. Powell Industries (POWL). This is an industry name with a market capitalization of $1.7 billion. We hold a 1% allocation of this stock in Inside Edge Capital’s growth portfolio and will consider increasing the size of our position with this decline highlighted on the daily chart. The company beat last quarter’s profit and bottom line, increased its dividend, and provided strong guidance going forward. Disclosure: Gordon owns POWL through his asset management company, Inside Edge Capital Management LLC. The above is subject to our Terms of Use and Privacy Policy. This content is provided for informational purposes only and does not constitute financial, investment, tax, or legal advice or a recommendation to purchase any securities or other financial assets. The content is general in nature and does not reflect your unique personal circumstances. The above may not be appropriate for your particular situation. Before making any financial decisions, you should strongly consider seeking the advice of your own financial or investment advisor. Click here for full disclaimer.
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