Small-Cap Value ETFs Rallying Hard: Here's Why

Small-cap fund iShares Russell 2000 ETF (IWM) has underperformed the S&P 500 this year. However, the trend seems to be reversing of late with small caps taking charge. Value ETFs in the spectrum of small caps have been especially doing well.

In the past five days (as of Sep 10, 2019), SPDR S&P 500 ETF (NYSE:SPY) (ASX:SPY) has added about 2.6% while IWM gained about 4.9% and Invesco S&P SmallCap 600 Pure Value ETF RZV increased around 11.7%. A dovish Fed, heightened trade war tensions, global growth worries, geopolitical risks and a decently growing U.S. economy have probably been working in favor of pint-sized stocks.

US Economy in Decent Shape; Fed Dovish

Investors should note that small caps are domestically focused and are less scathed by trade tensions or global slowdown. These companies, with lesser foreign exposure, gain when the economy is improving and currency strengthening.

The Fed meeting, which is going to start in mid-September, is expected to end on a dovish note. At the current level, according to CME FedWatch tool, there is a 91.2% chance of a 25-bp rate cut in the September meeting.

The bets over lower rates increased a bit in recent trading as U.S. GDP growth revised down in the second quarter to 2% (from 2.1% rate reported earlier) hurt by softer business investment and manufacturing. The growth rate followed a 3.1% uptick in the previous three-month period. Needless to say, tariffs and a global slowdown weighed on the U.S. economy, which compelled the Fed to act dovish.

Also, “small caps have more relative debt on their balance sheets. Small caps are stretched on debt to capital and net debt EBITA” per an article published on CNBC. If there is higher debt on the balance sheet, chances of low rates should benefit smaller-cap stocks.

Stronger Greenback: A Boon for Small Caps

But despite the dovish stance adopted by the Fed, the greenback has been gaining traction. Invesco DB US Dollar Index Bullish Fund UUP has advanced 2.6% in the past three months. Such strength in the U.S. dollar is a negative for the more-sensitive large-cap stocks. This should boost small-cap stocks to a great extent.

U.S. Consumer Spending Still Strong

Also, investors should note that while manufacturing and housing data point toward a slowdown early in the third quarter, strong consumer spending alleviated concerns about a recession.“While other parts of the economy may show some weakening, consumers have remained confident and willing to spend,” said Lynn Franco, senior director of economic indicators at the Conference Board (read: ETFs to Buy as Americans' Confidence Nears 19-Year High).

Investors should note that oil prices are not likely to shoot up this year given the global growth worries and a possible threat to demand. Savings at gas stations should also fatten consumer wallets. Overall, the inflationary picture is subdued, which in turn, might encourage consumers to spend more. With consumer spending making up about 70% of the U.S. economy, the trend should bode well for small-cap stocks.

Why Value?

Having said that, we would like to note that in the wake of a host of uncertainties like trade tensions, U.S. presidential election in 2020 and Brexit, it is better to stick to value stocks at the moment. After all, the “gap between how much foreign sales small caps have versus large caps has been narrowing in recent years,” according to Jill Carey Hall, Bank of American Merrill Lynch U.S. equity strategist. So, any global market shock might take away the edge small caps had been enjoying for long.

Invesco S&P SmallCap 600 Pure Value ETF RZV — Up 11.7% in the pas five days (as of Sep 10, 2019)

First Trust Small Cap Value AlphaDEX Fund FYT — Up 9.6%

Invesco S&P MidCap 400 Pure Value ETF RFV — Up 10.6%

First Trust Mid Cap Value AlphaDEX Fund FNK — Up 8.9%

iShares Morningstar Small-Cap Value ETF (CM:JKL) — Up 7.2%

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