Why Small Cap Stocks Are the Profit Rockets of the New Bull Market

Shah Gilani|July 28, 2023

There’s a good reason mega-cap tech stocks lifted benchmark indexes off their lows into a bull market. And a better reason why small caps are now outperforming big caps and will continue to outshine them as markets plow higher.

The mega-cap tech rally, which was initially all about the “Magnificent 7” (META, AAPL, AMZN, GOOG, MSFT, NVDA, TSLA) was predicated on two things: that the Fed was nearing the end of its vicious rate hiking cycle, and that the Big 7 would be the leaders in the brave new world of artificial intelligence.

It didn’t matter that the Fed wasn’t done raising rates at the beginning of this year. Smart traders knew they could raise more but would sooner than later either stop raising or cut rates if they’d gone too far and the economy started downshifting. They bet that the mega-cap tech stocks with real profits and cash flows, which got beaten up as rates rose, would be the first ones to rebound. It didn’t hurt that the Magnificent 7 all had some legitimate claim on the new AI narrative.

So, up they went.

Now it’s going on eight months later, and the mistrusted new bull market, having been led by a tiny handful of stocks, is broadening out and lifting most boats as the tide rises, and none moreso than small caps.

Small caps are usually the last group to join a new bull market. That’s because new bull markets aren’t trusted, mostly because they appear on the heels of a recession and bear markets.

But, if the economy is growing (which it is), and spending is robust (which it is), and interest rates are headed lower (which eventually they will be), then investors start looking for undervalued stocks, value plays, cyclical plays, and stocks with the most upside potential. That leads them inevitably to small caps.

We just got our first look at second quarter GDP, and it shows the economy growing at an annualized 2.4% pace. That’s faster than analysts consensus estimates and better than first-quarter growth of 2%.

And that’s with rates more than 500 basis points higher than they were at the beginning of 2022.

Underlying solid GDP growth, consumer spending is up 1.6%, the jobs outlook remains positive, wage growth is solid, and durable goods orders easily outpaced projections. Analysts are now either cancelling their recession calls or putting them off until 2024, and some have said a recession could come in 2025.

Honestly, though… there’s no recession in sight. In fact, it’s beginning to look like a Goldilocks economy – not too hot, not too cold, just right.

Investors see that and have been grabbing small cap stocks. That’s because small caps are chock full of the kinds of things investors want to see, which I mentioned above, and they pop as the economy rolls on and chugs higher.

The first month of the third quarter saw small caps, measured by the S&P SmallCap 600 Index, outshine big caps, posting a 4% gain for the month vs. a 2.6% gain for the S&P 500.

And while the S&P 500 is now only 5% from its all-time highs, “IJR,” the iShares S&P SmallCap Core ETF, which tracks the S&P SmallCap 600, is 16% from it’s all-time high. Which means there’s a lot more room for small caps to rise than there is for big caps at this early stage of the new bull market.

The below table, courtesy of DataTrek, one of my all-time favorite resources for amazing data and insights, shows how small caps have done this year, based on breaking down the S&P SmallCap 600 into sectors that are each covered by an ETF, the symbols in parentheses.

You can see that the former high-fliers, especially technology stocks, have cooled down while the sectors that do well in a Goldilocks economic environment start picking up the slack.

As long as the economy keeps growing and this bull market is mistrusted small caps, are going to be the place to be.

And right now, there’s one category of small caps that has breakout profit potential way beyond that of its larger cousins – tech stocks that are developing tomorrow’s AI technologies and the computer chips needed to run them.

You see, right now, there’s a conflict raging between the U.S. and China over control of the next generation of computer tech. China has already been using “spy chips” to secretly monitor the actions of U.S. companies and even private citizens like you, and if they get hold of the AI “SuperChips” that American companies are developing, it’s game over.

That’s why the U.S. is spending so much money on decoupling our chip production capabilities from China, and seeking to cut their access to powerful cloud computing services that they use to develop AI apps.

This “chip war” is going to create a high-demand market of historical proportions, and it could propel companies you’ve never heard of to potentially become the Googles and Microsofts of tomorrow.

And I know exactly what companies are most likely to thrive.

To get my full briefing, click here.