In the first half of 2023, U.S. small-cap stocks showed decent trends but lagged behind the S&P 500 (up about 16%) and Nasdaq Composite (up about 31.7%). The small-cap Russell 2000, an index tracking U.S. small-cap stocks, saw modest gains of around 7.2% during this period. The S&P 600 small-cap ETF (SLY) offered even muted performance of 4% in 1H.

However, the pint-sized stocks tend to gain momentum in 2H due to the better-than-expected U.S. economic recovery and a resilient consumer base. Since small-cap stocks are closely tied to the domestic economy, an uptick in economic outlook bodes well for small-caps.

Inside the Improving Sentiment About the U.S. Economy

The recessionary fears are ebbing in the United States. Goldman Sachs expects a 20% chance of a U.S. recession in the next 12 months, per a Yahoo Finance article. The firm had initially predicted a 25% probability of a recession, which is significantly lower than the 54% chance indicated by the consensus estimates mentioned in the Wall Street Journal, as quoted on the Yahoo article.

With the U.S. economy witnessing upbeat economic datapoints and Q2 earnings season unfolding in a decent manner, Goldman Sachs lowered their recession forecast. Bank of America (BAC) CEO Brian Moynihan is also cutting his expectation for a mild recession this year, mainly due to the resilience of the U.S. consumer, as quoted on Yahoo Finance.

The University of Michigan Consumer Sentiment Index for July jumped to its highest level since September 2021, indicating growing confidence in the U.S. economy. This unexpected increase reflects positive factors such as the slowdown in inflation and stability in labor markets. The University of Michigan report highlights a 19% surge in long-term business conditions and a 16% increase in short-run business conditions (read: Momentum ETFs to Ride Upbeat Data & Good Start to Q2 Earnings).

The Consumer Price Index for June and the Producer Price Index both indicated slower-than-expected increases in prices. Such fall in inflation may lead the Fed to go slow in its policy tightening spree, which is great for small-caps as well as regional banks. Additionally, weekly jobless claims were lower than anticipated, demonstrating the resilience of the labor market.

Winning ETFs in Focus

Against this backdrop, small-caps are likely to participate in the EPS revisions recovery. The upbeat sentiment around this group is palpable as evident from the 52-week highs hit by several of the group’s ETFs. Below we highlight a few of them.

Pacer US Small Cap Cash Cows 100 ETF (CALF Quick QuoteCALF - Free Report) ) – Up 1.6% on Jul 18; Up 18.3% YTD

The underlying Pacer US Small Cap Cash Cows Index uses an objective, rules-based methodology to provide exposure to small-capitalization U.S. companies with high free cash flow yields. The fund charges 59 bps in fees and yields 1.05% annually.

S&P Small-Cap Industrials Invesco ETF (PSCI Quick QuotePSCI - Free Report) ) – Up 1.6% on Jul 18; Up 20.1% YTD

The underlying S&P SmallCap 600 Capped Industrials Index measures the overall performance of the securities of US industrial companies which are principally engaged in the business of providing industrial products and services, including engineering, heavy machinery, construction, electrical equipment, aerospace and defense and general manufacturing. The fund charges 29 bps in fees and yields 0.81% annually.

Janus Small-Cap Growth ETF (JSML Quick QuoteJSML - Free Report) ) – Up 1.5% on Jul 18; Up 31.2% YTD

The underlying Janus Henderson Small Cap Growth Alpha Index selects small-sized capitalization stocks that are poised for smart growth by evaluating each company performance in three critical areas: growth, profitability, and capital efficiency. The fund charges 30 bps in fees and yields 0.57% annually.

S&P Smallcap Quality Invesco ETF (XSHQ Quick QuoteXSHQ - Free Report) ) – Up 1.5% on Jul 18; Up 18.3% YTD

The underlying S&P SmallCap 600 Quality Index is composed of 120 securities in the S&P SmallCap 600 Index that have the highest quality score, which is calculated based on the average of three fundamental measures: return on equity, accruals ratio and financial leverage ratio. The fund charges 30 bps in fees and yields 1.56% annually.

First Trust Active Factor Small Cap ETF (AFSM Quick QuoteAFSM - Free Report) ) – Up 1.5% on Jul 18; Up 18.3% YTD

The fund seeks to provide capital appreciation. Under normal market conditions, the Fund will invest at least 80% of its net assets (including investment borrowings) in U.S.-listed equity securities issued by small capitalization companies.The multi-factor quantitative methodology currently used by the Fund may take into account the following factors: value, momentum, quality and low volatility. The fund charges 77 bps in fees and yields 1.19%.