Maybe Some Goods For Risk Appetite: Small Caps Are Hot Again

In what good could be a dose of good news for the broader market and those looking for some positive vibes when it comes to investors' willingness to take on risk, small caps are breaking out.

Somewhat quietly, the widely followed iShares Russell 2000 ETF (NYSE:IWM), the largest small-cap exchange traded fund, is higher by 4.5 percent, a performance that narrowly tops the Nasdaq Composite and easily trumps the S&P 500 over the same period.

Investors have heard about small-cap strength by way of the rising dollar, which implies small-cap stocks and the exchange-traded funds that hold them should be beneficiaries of rising interest rates. So maybe IWM's recent bullishness is a case of market participants pricing in an interest rate increase from the Federal Reserve later this month or in July. However, there are some other surprising factors at play.

What Are These Surprises?

On an outright basis Wednesday, IWM took back the April highs and broke out on the chart. The SPY and QQQ cannot make that same claim, said Rareview Macro founder Neil Azous in a note out Thursday. On a relative basis, IWM is outperforming SPY. On a cross-asset correlation basis, the IWM/SPY ratio historically tracks crude oil and as you can see the ratio is starting to converge to the barrel at a faster rate after diverging the past few months.

There are some interesting things about IWM's correlation to crude. First, that correlation is being obeyed at the moment. Over the past month, IWM has gained about 45 cents for every $1 the United States Oil Fund (NYSE:USO) is up.

Second, the $26.4 billion IWM features only scant energy sector exposure. At a weight of just 2.8 percent, energy is merely IWM's second-smallest sector allocation ahead of only telecom. Said another way, the ETF's weight to financial services stocks is nearly 10 times its energy exposure.

Still, it would be advisable to not fight the oil/small-cap relationship.

That observation should not be a surprise given small caps are closely correlated to high yield, and high yield on account of the energy exposure is correlated to the barrel, adds Azous. In the end, the linkage between small caps, high yield, and crude oil is becoming more self-reinforcing all of a sudden.