After a lengthy run of tantalizing and disappointing investors, small-cap stocks appear to be finally finding solid footing. For the month ending May 16, the Russell 2000 Index is higher by 7.74%, perhaps signaling smaller stocks are ready to deliver more sizable gains.
Some related exchange traded funds are performing even better. The Invesco NASDAQ Future Gen 200 ETF (QQQS) surged 8.42% over the past month, and more upside could be in store for the Invesco ETF as multiple tailwinds mount.
For example, it was previously thought that small-caps, including QQQS holdings, needed the Federal Reserve to cut interest rates to notch upside. However, the “higher for longer” environment many experts are predicting could actually be beneficial to smaller stocks, because it signals the Fed is comfortable with the strength of the U.S. economy — arguably an indirect endorsement of domestically focused smaller firms.
Speaking of Rates …
While Fed rate cuts are headline-grabbers, 10-year Treasury yields have recently trended lower. That’s relevant to investors considering QQQS because small-cap stocks typically sport intimated correlations to those bond yields.
“That’s great for small-cap stocks because they stimulate economic growth. Small companies carry more debt than big firms and pay higher interest rates on those loans,” reported Lucas Downey for FXEmpire.
Another potential spark for QQQS is the notion, supported by data, that smaller stocks remain deeply discounted relative to large-cap fare. That’s particularly relevant regarding QQQS because the ETF allocates over 82% of its weight to healthcare and tech stocks. Those corners of the small-cap universe often trade at frothy multiples.
“Also, small-cap stocks are cheaper compared to the S&P 500. Since 1995, small stocks delivered a 3% valuation premium on average because of their higher long-term returns,” noted Downey. “Currently, small-cap stocks trade at a 27% discount relative to the S&P 500. They’ve rarely been cheaper.”
Beyond the economy and interest rates, another possible tailwind for QQQS is increasing biotechnology mergers and acquisitions activity. After a brisk first quarter of biotech consolidation, the trend continued in the early innings of the current quarter, with more than 20 deals announced since April 1. QQQS allocates more than 51% of its weight to the healthcare sector. In terms of small-caps, that typically means biotech. More consolidation in that industry could be a catalyst for QQQS. That’s because some of the ETF’s healthcare holdings fit the mold of credible takeover targets.
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
