How to trade strongest small-cap stock market rally in three decades

More power remains in the historic small-cap rally, according to State Street Investment Management.

“This is not a trivial rally,” Matt Bartolini, the firm’s head of global research strategists, told CNBC’s “ETF Edge” this week.

Bartolini cites a promising trend: Most Wall Street firms are raising, rather than lowering, small-cap earnings expectations. This translates into higher earnings per share estimates for this year, including the upcoming third and fourth quarters. He added that this quarter will likely see EPS growth of over 20%.

He cited stronger relative momentum and the “depth and breadth” associated with the small-cap stock market. “All 11 small-cap GICS sectors are outperforming their respective large-cap GICS sectors. This has not happened in over 30 years,” Bartolini said.

He added that small-cap stocks that are not heavily shorted are outperforming those that are heavily shorted, which is a sign of a sustainable rally. “If this were a comeback scrap rally with a short squeeze, it would be the opposite,” he said.

State Street SPSM And SLYGExchange-traded funds that track the S&P 600 Small-Cap and S&P 600 Small-Cap Growth indexes, respectively, are both up more than 20% this year, according to CNBC data. During the same period last year, SPSM fell almost 2% and SLYG rose only 0.86%.

Russell 2000 Index – the most popular small-cap stock benchmark and underlying index IWMThe iShares Russell 2000 ETF is also up nearly 20% this year; It recorded its best first half since 1991, when George HW Bush was in office.

“You have fundamental momentum, relative price momentum, [and] this idea [the small cap trade] it’s more permanent,” Bartolini said.

Phil McInnis, chief investment strategist at Avantis Investors, says the historic small-cap rally should be a signal to investors to look beyond the large-cap trade. “Some investors…don’t even realize [that] If you’re buying the S&P 500, yes, that gives you pretty good exposure to the stock market, but it’s not even close to the entire stock market,” he said on “ETF Edge.”

“I still see large-cap flows getting much more traction than small-cap flows,” he added, citing combined mutual fund and ETF data. “I still think small caps are overlooked by a lot of investors, and I think that’s a huge reason to have them in your portfolio.”

McInnis, whose firm manages numerous small-cap funds along with other stock and bond investments, highlights non-U.S. developed markets, emerging markets and mid-cap companies, as well as small-cap companies, as other asset classes where investors should consider adding exposure. He said emerging markets in particular performed “extremely well” last year.

IEMGThe iShares Core MSCI Emerging Markets exchange-traded fund is up more than 18% this year.

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