You might not have noticed, but small cap stocks are actually leading the market higher. In fact, the Russell 2000 is within striking distance of its all-time high, while large cap benchmarks still have a bit more to go before they take out old highs.

The trend towards small caps has become particularly pronounced in the past three months with the capitalization level clearly beating out large caps in this time frame. Current performances show small cap ETFs like iShares Russell 2000 Index (IWM) gaining about 13.5% in the time period, with SPDR S&P 500 ETF Trust (SPY) putting up gains of just 8.4% in comparison.

Behind the Surge

There are a couple of reasons for why investors might prefer small caps at this time including the following:

• Higher growth potential- With the lack of a taper by the Fed, some are taking a more risk-on stance in the markets, boosting the appeal of pint-sized securities that have more robust growth opportunities.
• Domestic Focus- Although many international markets are coming back, there is still a broad perception that the U.S. is the place to be for equities. Since small caps tend to have less foreign exposure, many investors have looked to this segment instead of their large cap counterparts.
• Less of a yield play- Dividend plays have certainly come back a bit in light of the ‘no taper’ announcement, but the outlook for these plays is still quite uncertain. Small caps aren’t exactly known for their income potential, so undoubtedly this ‘growth over income’ play has been some of the reason for the trend towards the space as of late.

However, some investors are starting to grow concerned by this run in small caps, thinking that this level of outperformance cannot continue. PEs are starting to get a little high for the segment (22.21 forward PE for the S&P 600), while some volatility thanks to D.C. could result in serious profit taking for small caps.

But what do you think about the small cap outlook?

Do you believe that the small cap rally can continue, or is new leadership about to take hold of the market?

Let us know in the comments section below!

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