Season of Small Caps — Evening Brief – 07.23.24
Recent trading activity in the U.S. equity markets has investors discussing that a shift in leadership from large-cap growth stocks to the laggards, or small-cap stocks, is possibly afoot amid the recent notable exodus from technology shares.
The small-cap sector has lagged well behind its larger peers and may now provide undervalued opportunities. The unexpected shift in sentiment has propelled small-cap growth far ahead of large-cap growth by a significant margin on a trailing one-month period.
The abrupt change in leadership is noticeable. Consider the Russell 2000 index (RUT), one of the worst-performing small-cap indices of the past several years. So far in 2024, the index is up only roughly 2%. In comparison, the broad equity market (SPY) has gained more than 16%, while the leader, large-cap growth (IVW), has surged about 23%.
The S&P 500, Dow Jones Industrial Average and NASDAQ have routinely hit new all-time highs in recent weeks. However, the Russell 2000 is still 8% below the record established three years ago. Small-cap stocks have been shunned for years due to interest rates remaining ‘higher for longer.’ However, given the significant possibility that the Federal Reserve will lower interest rates in September, the sector has reversed course in the last week or so.
Smaller companies are more likely to rely on borrowing money to fund their expansion (unlike giant corporations with billions of dollars). They suffered because they lacked easy access to financing. Now that inflation appears to be under control and the Federal Reserve is expected to cut interest rates, small-cap companies could experience a surge in value.
It’s too early to say with certainty whether small-caps and other lagging sectors will take the lead for an extended time, but some strategists predict a strong rally is ahead.
“The overlap in small caps is very sensitive to a Fed cut, and really the probability of a cut. I think it’s going to look like the October to December 2023 rally, which was almost 30%,” Tom Lee, Fundstrat global advisor, told CNBC on Monday “This one should be bigger because of the amount of short positioning and the amount of oversold [conditions] in the Russell 2000.” Lee expects a 40% rally in small caps “by the end of the summer.”
Meanwhile, strategists at Yardeni Research caution against overreacting to the latest surge in small-cap stocks. “Interest-rate cuts should help boost forward profit margins, but we doubt a few 25bps cuts to the federal funds rate will improve [small-caps] bottom lines significantly,” the firm told clients. “The problem might be that the most successful [small-cap] companies get acquired quickly these days before they can significantly boost the earnings/revenues/ margins of [small-cap] stock price indexes.”