Are Reports of Small-Cap Stocks’ Revival Prospects Premature?

, a widely followed benchmark of small-cap shares, has revived hope anew that this slice of the equity market is finally set to recover after a long stretch of underperformance. But we’ve been here before, multiple times in recent years. Is this time different? Maybe, but the evidence is still a bit thin.

Despite the new round of optimism, the burden of proof is still firmly on small caps to display relative strength. Year to date comparisons, however, still look ugly. The iShares Core S&P Small-Cap ETF have closed the gap rather dramatically and are now neck and neck with SPY, each posting near-4% rallies.

Given the recent strength, the case for a contrarian bet on small caps looks more compelling these days. Comparing IJR against a wide set of factor ETFs for year-to-date results reminds that small caps have underperformed most slices of the equity market. Assuming a reversion-to-the mean effect suggests that a degree of normalization may be brewing in favor of small firms.

The implication: expectations that the Federal Reserve will continue to lower interest rates at a time when the US economy still looks poised to expand may fuel an extended small-cap rally. Hope, it seems, is reviving once more for these stocks. For portfolios that are underweight small caps, or with a zero weighting, one can argue that the timing is ripe for making a calculated risk that the optimists are right this time.

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