Avoid Small Cap Stocks in 2025 Despite the Hype

There has been a lot of jubilation surrounding the rally in small cap stocks in recent months. However, investors and traders alike need to be careful about assuming that the small-cap area of the stock market will outperform in a meaningful way in 2025.

Although I do acknowledge that the Russell 2000 small-cap index has outperformed so far in the second half of 2024, that statistic is a bit misleading. I'd also note that we have all heard about how the small-cap stocks were going to outperform several times over the last two years. However, after a very short period of outperformance, small-caps have gone back to lagging behind the rest of the market. 

Don't get me wrong, I am not saying that there is no way that the Russell 2000 cannot finally outperform in 2025. It has been acting well recently, with a series of higher-lows and higher-highs. It has also made a new all-time high recently. All of this is positive. However, we're going to have to see a lot more upside follow-through before I can get overly excited about this area of the stock market.

Several issues concern me. First of all, everybody seems to be wildly bullish on the small cap sector. Again, we've seen this pop up many times over the past two years, only to see the group fade rather quickly. (In fact, its outperformance already seems to be fading. Last year, when it outperformed in Q4, it lasted into the New Year. This year, it's already showing signs of fading.)

Another concern is that even though the Russell 2020 was able to make a new high recently, it has not been able to push above its 2021 record highs in any material way on a weekly basis. Therefore, if it rolls back over in a material way soon, it will raise some real warning flags. 

Finally, even though the Russell 2000 has outperformed the S&P 500 and the Magnificent 7 tech index since July 1, it has underperformed for most of the rest of the year, including the rest of the second half of 2024. We all know that the Mag 7 stocks have outperformed year-to-date, but despite the way it has been portrayed around most of Wall Street, the Mag 7 have outperformed the small caps if you use any other starting point in the second half starting on August 1. In fact, the Mag 7 stocks have even outperformed since the election! 

In other words, the big cap tech stocks are still the most important leadership group in the stock market today. Don't get me wrong, if the Russell 2000 can break above its all-time highs from 2021 in a more significant manner, it will be very bullish for the small-cap sector of the stock market. Thus, I don't want to sound overly cautious right here.

I'm just saying that with the bullish sentiment for the small caps becoming quite extreme recently, I want to see this group actually breakout before we jump on board the train. We've just been disappointed too many times in this group in recent years not to be wary of all the bullishness that surrounds it right now.

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