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Small-cap stocks jump ahead of larger peers as US limps toward economic recovery

As stocks with a relatively small market capitalization have vaulted past their large-cap peers over the past three months, equity analysts see few hurdles to a continued rally for the market's smaller players on coronavirus vaccine hopes and economic recovery dreams.

"Small-cap dominance should remain as long as virus mutations don't render COVID vaccines useless and the surge in Treasury yields does not get out of control," said Edward Moya, a senior market analyst with OANDA, in an interview.

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Since Pfizer Inc. and BioNTech SE announced their long-awaited and encouraging coronavirus vaccine results on Nov. 9, 2020, the S&P 600 and the Russell 2000, both small-cap indexes, have climbed by 40.1% and 36.9%, respectively, through Feb. 22. Large-cap indexes have also risen, but not nearly as much. The S&P 500, for example, has risen just 10.5% and the Nasdaq Composite Index has risen 13.8% over the same period.

"Small caps have been unbelievably strong," said Steven DeSanctis, a small and midcap strategist at Jefferies, in a Feb. 19 interview.

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On Feb. 23, the S&P 600 closed down 0.6% on the day while the S&P 500 closed up 0.13%. Both indexes have been relatively flat on the week.

Small-cap stocks tend to be more levered to the overall health of the economy than their larger-cap counterparts, DeSanctis said. PBF Energy Inc., a New Jersey-based refiner, saw its stock plunge more than 77% in 2020 as demand for gasoline and other petroleum products plummeted due to lockdown measures from the pandemic. Since the vaccine announcement in November and expectations of a rise in demand, PBF's stock has risen roughly 183% through Feb. 22.

"The numbers are going in the right direction because the economy is doing better than people expected," DeSanctis said.

When nominal GDP growth climbs above 5%, small caps outperform large-cap stocks about 63% of the time, according to data from Royce Investment Partners. Small-cap stocks have outperformed their large-cap peers by an average of 4.4% during these times, the data show.

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Top individual stocks on small-cap indexes have also outperformed those on large-cap indices by a significant margin. Since the start of the year, the 10 top-performing stocks on the S&P 600, for example, have increased by an average of 123.27%, while the top 10 on the S&P 500 have increased by an average of 55.48%.

With earnings and revenues on the rise, and an ongoing vaccination rollout underway, investors believe the economy may have already rebounded, said Moya.

"Looking at the Russell 2000, one would think that we are already in a post-COVID world," said Moya. "With high hopes large parts of the economy will see some return to normalcy this summer, financial markets are ready to bet big on retail, financials and energy."

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Also lending support to a potentially lasting rally is that small-cap stocks have been trading at a significant discount to their larger-cap peers for the first time in over a decade.

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One measure of that discount and a stock's market value, the 12-month forward price-to-earnings, or P/E, ratio, was trading at 22.31x for the S&P 600 on Feb. 22, compared to the S&P 500's P/E ratio of 22.96. On June 8, 2020, the S&P 600's P/E ratio reached a record 38.49x, compared to the S&P 500's 25.14x ratio.

The best-performing stocks throughout the second and third quarters of 2020 were mega-cap stocks, such as Amazon.com Inc. and Microsoft Corp., which offered solutions to lockdown measures during the pandemic.

"Now, with multiple effective vaccines in distribution, traders are looking ahead to global consumers returning to 'the real world' of brick-and-mortar businesses, which are more often the types of smaller companies that make up the Russell 2000," said Matthew Weller, global head of research at GAIN Capital, in a Feb. 19 note.

But with small-caps outperforming large-caps while still trading at a discount, momentum will likely carry this rally.

"Traders have a tendency to buy what's been outperforming lately, so don't be surprised if small-cap indices like the Russell 2000 continue to outperform in the coming months," Weller wrote.