Small Cap Stocks Are Just So Hot Right Now

The U.S. stock markets have been the envy of the world this year.

Within the those markets, small-cap stocks have been outperforming large-cap stocks.

"Client conversations this week focused on the drivers and sustainability of recent small cap performance," said Goldman Sachs David Kostin.

"The recently-reconstituted Russell 2000 has outperformed the S&P 500 by 580 bp in the last two months (12.1% vs. 6.4%) as both rose to new all-time closing highs. The Russell 2000 has returned 22% YTD vs. 19% for the S&P 500. The rally began at the same time we published our in-depth report on small caps."

Small-cap stocks tend to do better than the S&P 500 during good times and worse during bad times.

Current global economic conditions have also been favorable for the risk exposures offered by that corner of the market. From Kostin:

Small caps’ leverage to US economic growth explains our EPS growth forecasts and much of their recent performance. Roughly 80% of Russell 2000 sales are derived domestically, compared with 66% for the S&P 500, which is more exposed to foreign economic growth and FX. Our economists expect that US GDP growth will accelerate from about 1.5% now to over 3% in 2014-2016. The high exposure to domestic growth also insulates small caps from recent investor concerns about the impact of a strong dollar and uncertain EM growth on US corporate earnings.

One thing that seems peculiar about Kostin's commentary was that rising interest rates he says rising rates have acted as a tailwind.

This is strange because small-cap companies tend to employ more financial leverage than large-cap companies.

From Kostin:

Rising rates have also provided a tailwind to Russell 2000 performance. Small cap cost of debt, and therefore margins and earnings, have a low sensitivity to moves in the Treasury yield. The concern that small caps could not take advantage of historically low interest rates was commonly cited by investors when we first published our small cap analysis, but the same insensitivity should support their performance as rates rise. See Exhibit 1.

It'll be interesting to see if this relationship holds up.