As the Market Rally Broadens, Here's One Way to Play Small-Cap Stocks

Recently, the stock market rally has been more inclusive, with sectors beyond the Magnificent 7 mega-cap tech stocks showing strength. In particular, banks have been performing well, aided by strong third-quarter earnings, which has boosted the Financial Select Sector SPDR ETF (XLF) to a new high. This broader rally has been welcomed by analysts like Jeff Jacobson from 22V Research, who believes it signals a positive outlook for small-cap stocks. Jacobson argues that small-cap stocks could not only break out but potentially outperform the broader market in the coming weeks.

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One key reason for this market broadening is the reduced focus on the Magnificent 7 stocks, a group of large tech companies that had been driving much of the market’s gains earlier this year. Since July, this group has underperformed, with only Meta Platforms managing to exceed its July highs. This rotation away from mega-cap tech stocks has provided room for other sectors to shine, particularly small-cap stocks. Jacobson believes this shift is a good sign for small caps, as the overall market remains strong while investors explore other opportunities.

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Jacobson also points to the upcoming earnings season as another potential catalyst for small-cap stocks, particularly as measured by the iShares Russell 2000 ETF (IWM). The last time earnings season occurred in July, IWM rallied by 9.44%, while the tech-heavy Nasdaq 100 (QQQ) declined by over 9%. As earnings reports for mega-cap tech companies begin to roll in, Jacobson expects a similar rotation out of tech stocks, which could once again benefit small caps like IWM.

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Banks and other financial stocks, which make up nearly 20% of the Russell 2000, could also play a crucial role in boosting small caps. If smaller banks and financial institutions deliver strong earnings results in the coming weeks, it could provide a significant lift to IWM. This was the case in the summer, and Jacobson believes a repeat performance could be on the horizon.

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The Treasury market is another factor that could support small-cap stocks. The recent rise in 10-year Treasury yields, which increased from around 3.6% to just over 4%, reflects a reduced likelihood of an economic contraction. According to Jacobson, rising yields driven by strong economic data are typically favorable for cyclical small-cap stocks. However, he notes that the market's initial reaction to higher yields often involves selling small caps due to concerns about potential headwinds. Nonetheless, Jacobson believes that if yields pull back without accompanying negative economic data, small caps could see a boost.

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In addition to these fundamental factors, there are technical and seasonal trends that may favor small caps in the near term. Since last December, the Russell 2000 has remained above its 200-day moving average, even during the market sell-off in early August. Jacobson highlights that IWM is currently only about 2% below a key resistance level of 225, which was reached in both July and September. With the market broadening and showing continued strength, he believes a breakout above this resistance level is increasingly likely. Furthermore, November and December have historically been strong months for IWM, adding to the positive outlook for small caps.

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Given the current market setup, Jacobson prefers to use options as a trading strategy. Specifically, he suggests selling IWM December puts with a 205 strike price to buy IWM December calls with a 230 strike price. He explains that during the sharp rally in July, there was a significant increase in call volatility as the market broke above the March and May highs. This is why Jacobson favors outright ownership of calls rather than an upside call spread, as he expects similar upward momentum.

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Meanwhile, U.S. stock indices, including the S&P 500 (SPX), Dow Jones Industrial Average (DJIA), and Nasdaq Composite (COMP), opened higher on Monday. The dollar index (DXY) also strengthened, while oil prices slipped, and gold was trading at around $2,649 per ounce. The bond market was closed in observance of Columbus Day.

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In other market news, Federal Reserve Governor Christopher Waller is scheduled to give a speech on the economic outlook later in the day. Shares of Boeing dropped by 1.5% after the company announced plans to cut 10% of its workforce and warned of a larger-than-expected third-quarter loss. Sirius XM shares surged more than 5% after news broke that Warren Buffett’s Berkshire Hathaway had purchased around $87 million worth of stock in the satellite radio company. On the downside, Caterpillar shares fell over 2.5% following a downgrade by Morgan Stanley, which cited mounting risks in the company’s construction industries segment.

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In China, mainland stocks resumed their rally despite concerns about the lack of detailed stimulus measures from the Ministry of Finance’s recent briefing.

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Technical analyst Michael Kramer of Mott Capital Management observed that the S&P 500 is forming a rising wedge pattern, a technical formation that often precedes a breakout in either direction. Kramer also pointed out that declining volume levels in S&P 500 futures are a classic signal that the pattern may be nearing its conclusion. Additionally, he noted a secondary bump-and-run pattern, which further suggests that the recent rally in the S&P 500 could be approaching its end.

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