Small cap stocks are having their best month ever

And that could portend good things about the underlying economy.

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David is giving Goliath a fight this month.

While most investors are largely focused on the bigger indices (the Dow, the Nasdaq, the S&P 500), the Russell 2000 index is quietly setting records. According to LPL’s Ryan Detrick, it’s up 18.4% for the month, its best performance ever.

Detrick wrote in a note yesterday that overall, post-election conditions appear somewhat “frothy” during the market’s broad rally. “Participation has not been limited simply to large cap stocks. After lagging the S&P 500 by more than 16% in the first quarter of 2020, last week the small cap Russell 2000 Index made its first record high in more than two years and is now outperforming the S&P 500 by 11% thus far in the fourth quarter,” Detrick wrote.

But the Russell’s rally may say more about the health of the underlying economy than many investors realize. Erik Sherman explained the dynamic in a piece for Fortune last spring. He wrote that while the Russell 2000 is not as widely watched as many other indicators, it can presage wider economic trends—both on the way down, and the way up.

When looking for clues about where the markets are headed, “a group of analysts, advisers, and investors point to the Russell 2000, which comprises small-cap and midcap companies, as important to track. The Russell has often presaged a crash, or blow-off top, and on the other side of a bear market indicated when conditions were again turning favorable,” he wrote.

There are a few reasons for that. First, as Nathan Moser senior vice president and portfolio manager of the Pax World Small Cap Fund told Sherman, small caps are domestically focused, with 80% of the revenue of the index coming from the U.S., vs about 40% for the S&P 500. That makes the Russell far more exposed to U.S. GDP growth than other indices.

When trouble is looming, small caps tend to have less access to financial resources to weather tough time, and a shorter business cycle. “As a result, when the economy is turning into a recession, we will observe negative signals from small stocks first, such as revenue and profit declines, layoffs, and even bankruptcies,” Dr. Tenpao Lee, a professor of economics at Niagara University, wrote in a note to Fortune. “He also pointed out that Russell-type companies are more flexible, so they can and will make faster adjustments like laying off employees, making economic impacts more obvious than with slower big businesses.”

Those forces are reversed as the economy turns the corner out of a recession, Sherman explained. “Then, when things really turn around (versus a short-term bump, followed by another fall), stocks on the Russell frequently lead the large-caps. When this happens, it tells you ‘investors are moving back into the riskier areas of the equities market,’ Wantrobski said.”

Certainly the Russell’s moves this week—and overall change in sentiment—are a welcome sight to investors who, some six months ago were expecting an extended recession or even a depression.

After all, as Detrick quipped in his note, “Nothing changes sentiment like price.”

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