In One Chart: Small-cap stocks are crushing it, but here’s a reason to ‘pause’ before jumping in

Small-cap stocks are kicking tail, taking names and generally looking good on the charts, says one of Wall Street’s most closely followed technical analysts. But near-term crowding means traders might want to await a “tactical pause” before jumping in.

“Small-cap everything looks better than large‐cap, with the exception of technology,” wrote Jeff deGraaf, chairman of Renaissance Macro, in a Thursday note, a day after the small-cap benchmark Russell 2000 index RUT, -0.83%  logged its 23rd record close of 2018, leaving it up 11.2% in the year to date.

The large-cap S&P 500 SPX, -0.68% in contrast, was up 3.5% in the year to date through Wednesday.

See: Small caps offer stock-market leadership amid tumult

The recent outperformance by small-cap stocks has been attributed in part to trade-war worries, with analysts emphasizing that smaller, domestic-focused companies that are less dependent on exports would be better suited to weather any damage. A cloudier outlook for global growth versus a booming domestic economy might also be a factor, analysts said, as well as the notion that smaller companies will reap more benefit from the corporate tax cut signed into law last year since they generally pay higher tax bills than large-cap multinationals.

Check out: Small-cap stocks are on a tear — but shares in tiny companies have done even better

DeGraaf sounded an agnostic note on the reason for the outperformance.

“The apparent insular nature of small‐caps to a trade war may be the catalyst, or it may be the longer‐term under‐performance small‐caps have experienced versus the SPX that is finally closing the gap; maybe it’s both, maybe neither?” he wrote.

Read: You can make more money on small-cap stocks by playing this overlooked index

The bottom line, he said, is that RenMac likes the trade; it’s well-positioned according to the firm’s proprietary model and small-caps’ relative performance has confirmed the strength. The only rub, he said, is that the strength is also recognized by investors in exchange-traded funds, or ETFs, with small-cap ETF flows now at levels associated with a pause or correction. For that reason, he writes on an annotated chart (see below) that investors should look for a “tactical pause” to buy.

“The long-term charts are good enough to suggest this isn’t a major top for small‐caps, but it’s a recognized trade that will probably provide a better entry point broadly for the asset class,” he said.

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