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Nov. 30, 2020, 8:07 a.m. EST

The Russell 2000 has had a powerful November — and the gains aren’t over

Small and midcap stocks will keep rocketing higher for 5 big reasons

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By Michael Brush, MarketWatch

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Smidcap stocks are on fire. The Russell 2000 /zigman2/quotes/210598147/delayed RUT +1.08% is up over 19% this month compared to 10% for the S&P 500 index /zigman2/quotes/210599714/realtime SPX +0.16% .

Will it continue? This group has been beaten and battered for so long that many people simply doubt the move. But this is a big mistake. I don’t know about the next few days ahead, but smidcaps will continue to do well over the next year for the following five reasons.

No. 1: Small companies run lean and mean

By next June the economy will be really hot. The debate then will be about inflation and whether the Federal Reserve needs to “take away the punch bowl” to contain prices. The reason: Politicians and the Fed have dumped the most stimulus on the economy ever relative to GDP. They’ve deployed more than even during either the 2008 financial crisis and World War II, when war spending served as de facto stimulus.

It’s a no-brainer that this will create rapid growth and inflation as the COVID-19 virus recedes as a problem.

This is an ideal environment for midcaps, defined as companies with a stock-market value of $2 billion to $10 billion, and small-caps ($300 million to $2 billion in market capitalization).

That’s because smaller companies run lean compared to large companies. So when prices go up, more of the gain falls to the bottom line. “Small companies have greater operating leverage so their profits grow faster,” says Jim Paulsen, market strategist and economist at the Leuthold Group. “Historically small companies have done a lot better compared to large companies when inflation goes northward. We prefer small to large amid expectations for a strong U.S. economic recovery.”

Already, earnings estimates for the S&P 600 are going up faster than estimates for S&P 500 companies. This trend will continue.

No. 2: A lot of investors still don’t believe

Many people just aren’t buying it. Lance Roberts, chief strategist at RIA Advisors, questioned the small-cap run on Twitter on Wednesday.

He is not alone. But this is actually bullish. It means there are more non-believers out there to come on board and buy your smidcap stocks, pushing prices higher.

“Small-caps are woefully underrepresented in most portfolios,” says Paulsen. “They have been doing so poorly for so long, many investors have favored the winners in large-cap.” As the rotation into small cap continues, “you will get more and more people lifting their exposure. This will add fuel to leadership cycle,” he says.

No. 3: Smidcaps are relatively cheap

This reflects the fact that they’ve been persistently unpopular, despite the recent gains. “Their price action has not kept up with earnings performance,” says Paulsen. Since the end of October, forward one-year estimates for the S&P 600 small-caps have gone up almost 8%, compared to 1.5% for the S&P 500.

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