Small-cap stocks are experiencing a significant surge, nearing their all-time highs after a prolonged period of underperformance. Fueled by the Federal Reserve’s rate-cutting cycle and speculation surrounding the upcoming presidential election, these smaller companies are attracting investor attention. Analysts are predicting continued growth, with some pointing to a potential "catch-up trade" before the year’s end, but the rally is also linked to the political landscape, making the future trajectory a complex mix of economic and political factors.
Key Takeaways:
- Small-cap stocks are on the rise, with the iShares Russell 2000 ETF (IWM) reaching its highest level since November 2021.
- The Federal Reserve’s rate cuts are a primary catalyst, making borrowing cheaper for smaller companies and boosting investor confidence.
- A potential “catch-up trade” is anticipated before year-end, suggesting further growth for small-cap stocks.
- Political uncertainty adds another layer of complexity, with a potential Trump victory expected to favor domestic small-cap companies due to anticipated policy changes.
- Despite recent gains, small-caps still lag behind large-cap counterparts in year-to-date performance, presenting a potential opportunity for investors.
The Small-Cap Rally: A Closer Look
The recent surge in small-cap stocks, as represented by the iShares Russell 2000 ETF (IWM), is a noteworthy development in the market. After climbing 1.7% on Wednesday to its highest level since November 2021, the IWM is now on a four-session winning streak and is within 8% of its all-time high. This rebound is particularly significant considering the relative underperformance of small-caps compared to their large-cap peers throughout much of 2024.
The Federal Reserve’s Influence
A key driver behind this resurgence is the Federal Reserve’s recent decision to initiate a rate-cutting cycle. The half-point reduction last month has injected a much-needed shot of confidence into the market, particularly benefiting smaller companies. Lower interest rates translate to reduced borrowing costs, enabling these companies to expand their operations, invest in growth initiatives, and ultimately increase profitability.
This positive impact isn’t just theoretical; investors are actively betting on the economy avoiding a recession. Small companies, being more sensitive to economic downturns, stand to gain significantly if this optimistic view materializes. The market’s pricing in further rate cuts, with a high probability of a quarter-point cut in November and another in December, further emphasizes this sentiment.
The Political Wildcard: A Trump Presidency?
Adding another layer of complexity to the small-cap rally is the upcoming presidential election. Several analysts are highlighting the potential impact of a Donald Trump victory on the performance of these companies. Eric Johnston, chief equity and macro strategist at Cantor Fitzgerald, stated in a recent note, "We believe that the chances that Trump will win the election are far higher than what is priced into stock prices." His assessment stems from recent polls showing a tight race between Trump and Vice President Kamala Harris.
Johnston’s analysis, while bold, reflects a specific viewpoint. He argues that a Trump win would likely bolster domestic companies for several reasons: "With a Trump win, we would expect this will benefit domestic companies due to 1) lower tax rates 2) similar or greater spending than current 3) China product tariffs making U.S. goods more attractive 4) less financials and overall small business regulation." It’s crucial to note that Cantor Fitzgerald CEO Howard Lutnick serves as co-chair of Trump’s transition team, a potential conflict of interest worth considering when evaluating this perspective. This, however, does not invalidate the potential impact of such policies on small-cap companies. More fundamentally, it highlights a substantial driver of activity within the market.
The Analyst Perspective and Potential Catch-Up Trade
Beyond the macroeconomic and political factors, there’s a growing belief among analysts that a significant “catch-up trade” may be on the horizon. JC O’Hara, chief market technician at Roth MKM, pointed out in a recent note that, "there could be a ‘catch-up trade into year-end which would benefit smaller cap growth companies." He highlighted several specific small-cap companies poised for growth, including Hanesbrands, Dime Community Bancshares, and Insight Enterprises. These companies, he suggests could witness elevated returns due to improving market sentiment towards small-cap companies overall.
This "catch-up trade" theory suggests that small-caps, despite their recent gains, still haven’t fully caught up to the performance of large-cap stocks in 2024 to date. With the IWM up nearly 13% compared to the S&P 500’s 22% increase, this gap represents a potential opportunity. This highlights two competing forces at play, the ongoing small-cap resurgence, potentially reaching an inflection point, and the inherent volatility that comes with investing in smaller companies.
Risks and Considerations
While the outlook for small-cap stocks appears positive, it’s crucial to acknowledge potential risks. The inherent volatility associated with smaller companies is a significant factor. Their performance is often more sensitive to economic cycles and market fluctuations. While the current sentiment is bullish, a sudden shift in economic conditions or political developments could reverse this trend. Furthermore, different interpretations exist on the probability of a Trump win and the potential ramifications it could have on the economy. While it’s true that lowered tax rates and reduced regulations could benefit small businesses, the specifics of such policies are complex and difficult to predict with certainty.
Conclusion: Navigating the Uncertainties
The recent surge in small-cap stocks presents a compelling investment narrative, but one that needs careful consideration. While the Federal Reserve’s rate cuts and the potential for a "catch-up trade" paint an optimistic picture, the significant influence of the upcoming US presidential election adds a considerable layer of uncertainty. The potential for either increased or decreased spending from the federal government must be considered. Thus, understanding, analyzing and weighing the multifaceted factors at play — monetary policy, economic outlook and potential political shifts — is essential for investors seeking to navigate this dynamic market environment. The future trajectory of these investments remains inextricably tied to these crucial economic and political variables. As always, thorough due diligence and a well-diversified portfolio are crucial components of successful investing within this sector.
