Here's the Best Place to Look for Stock Market Gains in 2021

Investors got a nice rally on Wall Street on Tuesday, as enthusiasm about the prospects for a full economic recovery in 2021 has taken hold of market participants. Gains were broad-based, with the Dow Jones Industrial Average (DJINDICES: ^DJI), S&P 500 (SNPINDEX: ^GSPC), and Nasdaq Composite (NASDAQINDEX: ^IXIC) all climbing 1%. For the Nasdaq, gains were enough to send the index to a new record.

Index

Percentage Change

Point Change

Dow

+1.13%

+338

S&P 500

+1.29%

+47

Nasdaq Composite

+1.25%

+155

Data source: Yahoo! Finance.

Perhaps the most remarkable part of the stock market’s gains on Tuesday was how well the small-cap segment of the market performed. Today’s move of more than 2.3% was enough to send the performance of the Russell 2000 Index of small-cap stocks above the S&P 500’s gains for the year to date. After lagging large-cap stocks over the past several years, small-caps look like they’re setting the stage for a reversal of fortune.

How small-cap stocks have fared

Throughout much of the bull market of the 2010s, small-cap stocks weren’t able to keep up with the large caps in the S&P 500. You can see below just how wide the disparity got at times.

^RUT data by YCharts.

Coming into 2020, large caps had built a lead of 160% to 116%, dating back to late 2010. The coronavirus bear market only made things worse, with the Russell 2000 taking a big hit. At their worst levels in March, the S&P 500’s gains had dropped to around 80%, but small caps had fallen all the way back to about a 30% gain.

But small caps are fighting back. Take a look at how the two sub-asset classes have done so far in 2020:

^RUT data by YCharts.

For the first time all year, the Russell 2000 has caught up to and edged out the S&P 500. That’s a sign that small-cap investors are hoping for some sustained gains ahead.

The bull argument for small-cap stocks

Most stock market commentators point to the conditions in the market over the past 10 years as favoring large-cap stocks. In particular, with the global economy growing, the biggest multinational companies were in the best position to take maximum advantage of new opportunities abroad. Moreover, many of the top large-cap stocks are in the technology industry, and tech has been one of the strongest sectors for quite a while.

Image source: Getty Images.

By contrast, the recent turnaround for small-cap stocks comes amid greater optimism about the prospects for U.S. economic strength. That benefits small caps, in particular, for several reasons:

  • Smaller companies tend to have more localized business footprints that rely more on domestic customers. They can’t count on serving foreign markets when the U.S. economy is in recession, taking away a key source of diversification.
  • Smaller companies are typically more highly leveraged both financially and to their own business success. It takes big changes to move the needle at top large-cap companies, but for small caps, even incremental improvement can push share prices up sharply.
  • After a decade of tough performance, small caps are more reasonably valued as a group than their large-cap counterparts.

Take a look at small caps for 2021

Many investors ignore small caps because they see smaller companies as having higher risks. That’s often true, but shareholders also get better return potential in exchange. For many, that’s a trade-off worth making, and a full recovery in 2021 would likely benefit small-cap stocks even more than the stock market as a whole.