Small-cap stocks post strongest first half since 1991

Small-cap stocks have staged one of the market’s strongest runs this year, giving investors a reason to look beyond the mega-cap names that have dominated recent headlines. State Street Investment Management says the move is being backed by earnings expectations and broad participation, two signals that can matter more than a quick price spike.

Matt Bartolini, State Street’s global head of research strategists, told CNBC’s “ETF Edge” that the rally is “not a junk rally.” In market terms, a junk rally usually means weaker or heavily shorted stocks are bouncing for technical reasons rather than because the business outlook has improved.

Bartolini pointed to earnings revisions as one reason for his view. He said more Wall Street firms are raising small-cap profit expectations than cutting them, which has lifted earnings-per-share estimates for this year, including the third and fourth quarters. Earnings per share, or EPS, measures a company’s profit divided by its share count, and rising estimates can support stock prices if investors believe companies are getting healthier.

He added that the current quarter is likely to show EPS growth of more than 20%. Bartolini also cited stronger relative momentum, meaning small caps are gaining ground compared with large caps, and wider participation across the group.

According to Bartolini, all 11 small-cap sectors under the Global Industry Classification Standard, known as GICS, are beating their large-cap sector counterparts. GICS is the common framework that groups stocks into sectors such as technology, financials and industrials. Bartolini told CNBC that this has not happened in more than 30 years.

Another detail he highlighted: small-cap stocks with lower short interest are outperforming the ones that are heavily shorted. Short interest refers to shares investors have borrowed and sold in a bet that the price will fall. When heavily shorted stocks jump, short sellers can rush to buy shares back, creating a short squeeze. Bartolini said a squeeze-driven rally would show the opposite pattern.

Several small-cap funds have reflected the move. CNBC data show State Street’s SPSM, which tracks the S&P 600 Small-Cap Index, and SLYG, which tracks the S&P 600 Small-Cap Growth Index, are each up more than 20% this year. At the same point last year, SPSM was down nearly 2%, while SLYG was up 0.86%, according to CNBC data.

The Russell 2000 Index, a widely followed small-cap benchmark and the index behind BlackRock’s iShares Russell 2000 ETF, ticker IWM, is up close to 20% this year. CNBC said that marks its best first half since 1991.

Phil McInnis, chief investment strategist at Avantis Investors, told “ETF Edge” that investors focused on the S&P 500 may not be getting exposure to the full U.S. stock market. The S&P 500 covers large companies, while small caps represent a different slice of publicly traded businesses.

McInnis said large-cap fund flows still appear to be getting more attention than small-cap flows, based on combined mutual fund and ETF data. His firm manages several small-cap funds, as well as other stock and bond strategies.

McInnis also said investors should consider exposure to non-U.S. developed markets, emerging markets and mid-cap stocks. He singled out emerging markets as having performed “tremendously well” over the past year. CNBC data show the iShares Core MSCI Emerging Markets ETF, ticker IEMG, is up more than 18% this year.

This story draws on original reporting from CNBC.