Small is still beautiful for Wall Street’s stockpickers. The S&P 500 index of US large capitalisation stocks may have recently reached three-year highs but small-caps have beaten that performance.

Two key indices for small caps have reached all-time highs after continued gains this year. The Russell 2000 index reached its peak of 677.56 last week while the S&P 600 index of small-cap stocks also achieved an all-time high of 352.09.

The Russell 2000 is up 3.2 per cent so far this year while the narrower S&P 600 is up 6.1 per cent. That compares well with performances of the flagship, large-cap indices for the US market. The Dow Jones Industrial Average has lost 1.7 per cent on the year while the S&P 500 large-cap index has put on only 1.6 per cent while the Nasdaq Composite is flat.

The relative performance of small caps is even more striking considering they are less dependent on the energy stocks. Howard Silverblatt, equity market analyst at Standard Poor’s, noted that without energy, the S&P 500 index would be down 0.1 per cent for the year, while the S&P 600 index would still be up by 3.7 per cent.

The performance of small-caps has defied the swell of market forecasts at the start of the year that investors would soon begin to rotate money out of small caps into higher-quality, larger-cap stocks that might prove to be a more defensive investment in an environment of rising interest rates.

Some market commentators warn investor demand for small caps is approaching a bubble. “Small-cap stocks are hot now, just as technology and [initial public offerings] were in the late 1990s,” Mr Silverblatt said.

Edward Hemmelgarn, who helps manage $800m in small- and mid-cap portfolios at Shaker Investments, said that the sector “is exhibiting similar characteristics to the 90s dotcom era” but added that the trend could go on “for another year”. He said a partial explanation for the rise of small-cap stocks has been the broader climate in the US market, currently driven by trading and technical investing rather than fundamentals.

“These stocks will go up until they miss some fundamentals, and that just means they’ll have a lot further to fall,” he said.

The overall the S&P 600 index is trading on a multiple of 2005 earnings of 18.5 times. That represents about a modest 11 per cent premium to the S&P 500’s 16.6 times multiple. But some small cap sectors are more expensive, offering a glimpse of the potential for correction. The technology sector is trading on a multiple of 29 times while healthcare is rated at 26 times.

Aside from fundamental factors, small-cap companies could be affected by external issues outside their control. Joseph Zock, who helps manage $1.2bn for Capital Management Associates, said that a large-scale terrorist attack, or anything that could be seen as a threat to global geopolitical stability, could to trigger a “flight to quality that will penalise small-caps because they don’t have a PR machine that screams ‘safety’”.

However, barring such an event, Mr Zock thinks small-caps could buoyed further by rising mergers and acquisition activity and an improved earnings outlook. Satya Pradhuman, small-cap strategist at Merrill Lynch, noted that M&A announcements among companies with a market capitalisation of less than $2bn increased to 87 in the second quarter, from 65 in the prior three months. That would imply that it is not only Wall Street’s stockpickers that find small caps attractive.

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