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Unleashing the Underdog: Will Small Caps Steal the Show?

XChange NewsletterApril 10, 2024 | 3 min read
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Editor's note: Any and all references to time frames longer than one trading day are for purposes of market context only, and not recommendations of any holding time frame. Daily rebalancing ETFs are not meant to be held unmonitored for long periods. If you don't have the resources, time or inclination to constantly monitor and manage your positions, leveraged and inverse ETFs are not for you.

Large cap* tech stocks are definitely the cool kids of the market, with all the focus on the Magnificent 7 (Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta Platforms and Tesla) and artificial intelligence (AI). But small caps* could offer up their own trading opportunities this year given the group’s sensitivity to Federal Reserve rate policy and the fact the Russell 2000 Index* is still below its 2021 high.

Small caps have perked up a bit lately, although in recent years the relative performance story vs. large caps is a sad one. For the five years ending March 31, 2024, the Russell 2000 Index has an annualized return of 8.12% (FTSE Russell), compared with 13.14% for the S&P 500 Index (S&P Dow Jones Indices). Talk about large cap dominance.

Also, the Russell 2000 has yet to clear its 2021 high, while the S&P 500 seems to set new records on a daily basis. Of course, the performance of mega cap tech and the Magnificent 7 have been even better lately. With many large cap and tech benchmarks at all-time highs, do small caps have more gas left in the tank?

Bullish Catalysts for Small Caps

There are several tailwinds that could boost small caps and even help them potentially outpace their larger peers:

  • Fed rate cuts: The Fed’s latest “dot plot” released in March signaled three potential quarter-point rate cuts in 2024. Noted bull Tom Lee at Fundstrat thinks small caps could be the biggest beneficiaries of rate cuts, MarketWatch reports. It makes sense because small caps tend to have more financial leverage. Price targets should be taken with a grain of salt, but Lee is calling for the Russell 2000 to rally 50% this year and top 3,000 for the first time, according to the report. Still, it can be fun to root for the underdog after the dramatic underperformance of small caps historically.
  • Valuations: Price-to-earnings ratios* aren’t a short-term timing signal but the recent broader participation of small caps could be a sign that investors are seeing bargains in small caps. From a relative valuation standpoint, small caps are the cheapest they’ve been in 25 years, according to a recent Morningstar The Long View podcast. The Russell 2000 is trading at about 13 times earnings today while large caps are around 20 times earnings and the Magnificent 7 are at about 40 times earnings, according to the report (Morningstar).
  • Sector rotation: One factor that can impact the relative performance of large vs. small caps is what’s going on under the surface of markets in the various sectors. For example, the recent leadership of the industrials sector combined with a stumble in the tech sector has helped small caps.

Sector Allocations of the S&P 500 vs Russell 2000

SectorS&P 500 (%)Russell 2000 (%)
Health Care12.415.3
Consumer Discretionary10.310.9
Consumer Staples6.03.3
Real Estate2.35.6

Source: FTSE Russell Indexes, S&P Dow Jones Indices, as of March 31, 2024. Data subject to change.

Bearish Potential Setups for Small Caps

It’s possible the recent strength in small cap stocks is just another head fake, and we’ve had plenty of those in recent years. And who wants to bet against Nvidia and the other large-cap tech darlings? Here are some reasons why small caps could lead to the downside:

  • Show me the earnings: It could be argued that AI plays like Nvidia and Meta Platforms are priced to perfection given all the hype about how AI will change the world. At the same time, it can’t be denied that these big companies are churning out a ton of profit. Meanwhile, about a quarter of all Russell 2000 companies are unprofitable, Investment News reported. Investors are going to want to see earnings improvement from the smalls at some point.
  • The Fed and the economy underdeliver: If small caps are one way to attempt to play rate cuts in 2024, then the opposite is also true. For example, if inflation heats up and the Fed is forced to stay on pause or even hike, then all bets are off. Similarly, small caps tend to be more cyclical than large caps. That means if the economy slows meaningfully, small caps could be shunned by investors.

Leveraged Trading Plays for Small Caps

Traders who want to express a view on small caps in either direction can explore the Direxion Daily Small Cap Bear 3X Shares (Ticker: TZA) and Direxion Daily Small Cap Bull 3X Shares (Ticker: TNA). TZA seeks daily investment results, before fees and expenses, of -300% of the performance of the Russell 2000 Index. TNA, on the other hand, seeks daily investment results, before fees and expenses, of 300% of the performance of the Russell 2000 Index.

For current fund holdings, please click the links above. Holdings are subject to risk and change.

*Definitions and Index Descriptions

An investor should carefully consider a Fund’s investment objective, risks, charges, and expenses before investing. A Fund’s prospectus and summary prospectus contain this and other information about the Direxion Shares. To obtain a Fund’s prospectus and summary prospectus call 866-476-7523 or visit our website at A Fund’s prospectus and summary prospectus should be read carefully before investing.

Leveraged and Inverse ETFs pursue daily leveraged investment objectives which means they are riskier than alternatives which do not use leverage. They seek daily goals and should not be expected to track the underlying index over periods longer than one day. They are not suitable for all investors and should be utilized only by sophisticated investors who understand leverage risk and who actively manage their investments.

The Russell 2000® Index is a trademark of Frank Russell Company (“Russell”) and has been licensed for use by the Trust. The Direxion Daily Small Cap Bull and Bear 3X Shares are not sponsored, endorsed, sold or promoted by Russell. Russell makes no representation regarding the advisability of investing in the Direxion Daily Small Cap Bull and Bear 3X Shares.

The Russell 2000® Index measures the performance of approximately 2,000 small-capitalization companies in the Russell 3000® Index, based on a combination of their market capitalization.

The S&P 500® Index (SPXT) is designed to be comprised of stocks that are the 500 leading, large-cap U.S. listed issuers. The securities are selected on the basis of market capitalization, financial viability of the company, sector representation, public float, liquidity and price of a company’s shares outstanding. The Index is a float-adjusted, market capitalization-weighted index.

One cannot directly invest in an index. Past performance does not guarantee future results.

Direxion Shares Risks – An investment in each Fund involves risk, including the possible loss of principal. Each Fund is non-diversified and includes risks associated with the Funds’ concentrating their investments in a particular industry, sector, or geographic region which can result in increased volatility. The use of derivatives such as futures contracts and swaps are subject to market risks that may cause their price to fluctuate over time. Risks of each Fund include Effects of Compounding and Market Volatility Risk, Leverage Risk, Market Risk, Counterparty Risk, Rebalancing Risk, Intra-Day Investment Risk, Other Investment Companies (including ETFs) Risk, Cash Transaction Risk, Passive Investment and Index Performance Risk, and risks specific to investment in micro-cap, small- and/or mid-capitalization securities. Investing in micro-capitalization companies are significantly more volatile as they face greater risk of business failure than companies considered small and/or mid-capitalization companies. Investing in small and/or mid-capitalization securities involves greater risks and the possibility of greater price volatility than investing in larger, more-established companies. Additional risks include, for the Direxion Daily Small Cap Bull 3X Shares, Daily Index Correlation Risk, and for the Direxion Daily Small Cap Bear 3X Shares, Shorting or Inverse Risk and Daily Inverse Index Correlation Risk. Please see the summary and full prospectuses for a more complete description of these and other risks of each Fund.

Distributor: Foreside Fund Services, LLC.

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