Immediately after the election, the S&P 600 SmallCap Index blasted 6% higher, breaking through overhead resistance and hitting a new all-time high.
A little more than a month later, the index is still higher by 5%.
What is most notable, however, is that the upside breakout signaled a major change for small caps.
For the entire duration of the current bull market, the small-cap indexes have gone nowhere. In fact, the last major peak was exactly three years prior to their breakout, on November 5, 2021.
So, Why the Breakout?
First off, the election is over and we have a clear winner. That removed the overhang of uncertainty going into the event and sparked a relief rally.
Second, the Trump administration will almost certainly be pro-business, pro-U.S., and work to cut regulations and taxes. The corporate tax rate could go from 21% to 15%. These initiatives should be very friendly for stocks, including small caps.
Third, the appointment of Elon Musk to slow/slash government spending might actually work. Love him or hate him, it’s hard to argue that Musk hasn’t accomplished what many think was impossible, several times. If successful, concerns about a U.S. government debt crisis could prove to be overblown. That could be a positive for the market.
Fourth, the market reacts favorably to rising revenue and earnings expectations, which are going up for 2025 on expectations of Trump’s business-friendly agenda.
Finally, the Fed just cut rates, again. And Powell did not sound overly hawkish during his press conference.
Why Haven’t Small Caps Kept Moving Higher?
Of course, there are plenty of risks out there too. And the market began to focus more on emerging risks in the weeks since the election.
First and foremost, Jerome Powell has begun to dial back on rate cut talk.
There has been some debate about whether the Fed should be cutting at all given how strong the economy and labor market is. While Powell sounded relatively dovish during his FOMC meeting press conference on November 7, he’s sounded more hawkish since, at one point saying, “... the economy is not sending any signals that we need to be in a hurry to lower rates.”
Second, yields have continued to rise. The 10-year yield is sitting at 4.4% as of mid-December. While the relationship between yields and the stock market gets fairly nuanced, the bottom line right now is that yields have shot up to levels where the market is getting a little uncomfortable.
Third, there is some uncertainty out there around potential impacts to certain areas of the market due to Trump’s agenda. The best example is Big Tech, which could be in the crosshairs of Trump’s pick of Brendan Carr for chairman of the FCC.
Lastly, following the election, investors got bullish very quickly. The Bull/Bear ratio shot up to 2.9, and a lot of “junk” stocks rallied, with some ascending to completely unreasonable levels. While a Bull/Bear ratio north of 3.0 can certainly be sustained during a market rally when the fundamentals support it, it’s not entirely surprising that we’ve seen some turbulence following such a significant post-election relief rally.
What’s Next?
It’s been a wild ride since the election. And there are a lot of moving pieces under the hood that will cause certain small-cap sectors, let alone individual stocks, to do better/worse than others as we move forward.
But big picture, I think the future for small caps looks quite bright in an environment where there’s a renewed focus on U.S. companies, fewer regulations and lower taxes.
The S&P 600’s breakout to all-time highs is something I’ve been waiting for, and now that it’s happened the odds of the index rising further have increased.
Whether you agree with Trump’s agenda or not, the bottom line is that stocks tend to react well to expectations of higher revenue, profits and profit margins. And that’s the setup we’re looking at.
For broad-based small-cap exposure, I’m a big fan of high-quality ETFs, like the iShares S&P 600 Core ETF (IJR) and the Vanguard Small Cap Growth Index ETF (VBK), which offers a little more exposure to the growth end of the small-cap spectrum.
For those wanting to buy individual small-cap stocks the best thing to do is grab a subscription to my Cabot Small-Cap Confidential advisory, in which I cover the best small-cap stocks I can find in the market. You can learn more, and grab a trial subscription, by clicking here today.
