SCHA: A Good Option To Play The Potential Small-Cap Breakout

Something good could be finally brewing in the small-cap space as the long consolidation phase looks to be breaking out. This is a potentially bullish signal and should mark the end of recent underperformance. This article looks at whether the Schwab U.S. Small-Cap ETF (NYSEARCA:SCHA) could be about to catch up with the S&P500 (SPY).

Small-Cap Underperformance

SCHA has underperformed the S&P500 in most timeframes, but the divergence is striking over three years. SCHA is back where it was in February 2021 while the S&P500 is rallying strongly into new all-time highs.

There are various reasons for this underperformance. A large part can be attributed to the performance of the “Magnificent 7” and the huge tailwind these have provided to the S&P500 and the Nasdaq (QQQ).

SCHA has no such tailwinds; it is massively diversified, and its top holding is only 0.41% of the fund. It has much less stocks from the Tech sector and its holdings are much more sensitive to interest rates than the cash rich stocks of the SPY. Many small-cap companies need a constant source of funding and when rates are high like they are now, growth is stifled.

Breaking Out

SCHA has been stuck in a trading range since early 2022. Support at $38.50 has held strong, but so has resistance around $46. However, after four failed attempts at breaking out, the current rally may finally be successful and is trading above resistance at $47.23.

The December 2023 monthly close was at $47.24 so if SCHA can close February just slightly higher, it would be the highest monthly close since March 2022. If it can close above $47.36, it would be the highest monthly close since December 2021.

One issue with the break of the current trading range is that it remains at lower highs with the 2021 top. The SPY and QQQ are trading at all-time highs with no historical resistance. SCHA would still need to clear resistance at $52 and the $55.46 top to have a clear run higher.

Even still, the recent break has a good chance of signaling some relative strength and a catch-up with other indices. That could mean SPY goes sideways while SCHA continues higher, or simply SCHA rallies more than SPY.

SCHA

SCHA may finally be breaking out as rate cuts are on their way in 2024. Whether they arrive in May or June or even later may not matter too much, as investors will most likely front-run the first cut and buy small-caps in expectation of a better environment going forward.

SCHA is a good choice for gaining exposure to small caps as it consistently outperforms the benchmark, the Russell 2000 ETF (IWM).

This is partly due to the expense ratio being smaller. At just 0.04%, it compares favorably to IWM’s 0.19%. SCHA holds a blend of 1730 small-cap blend stocks, while IWM holds 1,948. The big difference comes from the weightings as SCHA’s top 10 holdings make up a very small 2.8% of the fund while IWM is 4.54%.

SCHA and IWM passively track different underlying indices, but the differences in the holdings don’t seem all that different. IWM is slightly more concentrated in Healthcare, which might be a drag.

SCHA outperformance is consistent over 1, 3, 5 years and the long term. The cumulative effect is significant.

SCHA is therefore my preferred way of owing small-cap stocks.

Risks

The biggest risk to owing SCHA comes from a “fake” breakout. This is when the breakout reverses back lower again. To make matters worse, the breakout often attracts some short-term buyers. If the breakout fails, there can be a rush for the exits as these short-term traders close out losing trades. A monthly close above $47.36 in February would make the breakout more reliable.

Owning small-caps also carries other risks. Many of SCHA’s holdings will be unprofitable companies. If rates stay high and dovish expectations don’t play out, some of these companies could struggle.

Regional banks are also a risk and the banking “crisis” has been simmering quietly under the surface since it bubbled over last year. SCHA holds 14.7% of its portfolio in Financials.

Conclusions

It appears small-caps are breaking out from a long consolidation, although a monthly close above $47.36 is still needed to really confirm its validity. This should signal some outperformance is due to catch up with the S&P500.

SCHA is a good fund to own for a small-cap rally. It is similar to IWM, but consistently outperforms and its holdings are less concentrated in the top 10. Furthermore, its expense ratio is much lower.