Small-Cap Stocks Surge on Rate Cut Hopes, Outperforming Tech in a "Rotation" Trade
Small-cap stocks are on a tear, eyeing their fifth consecutive day of gains on Tuesday. The iShares Russell 2000 ETF (IWM) surged 1.9%, propelling the index to a cumulative gain of over 9% across the last five sessions. This remarkable streak represents the Russell 2000’s best five-day performance since June 2020.
The turbocharged rise of small caps is attributed to the growing certainty that the Federal Reserve will lower interest rates at its September meeting. The Russell 2000 rally kicked off last week, driven by June inflation data coming in below expectations, sparking traders’ speculation about rate cuts. The CME Group’s FedWatch Tool now indicates a full 100% probability of an interest rate cut in nearly two months, marking the first reduction in borrowing costs since 2020. On Monday, Fed Chair Jerome Powell struck a dovish tone, acknowledging that recent inflation reports bolster confidence in returning to the 2% target, effectively hinting at forthcoming rate cuts.
Key Takeaways:
- Small-cap stocks are experiencing a five-day surge, fueled by expectations of interest rate cuts. The
Russell 2000 index has seen its best five-day performance since June 2020, driven by positive
inflation data and dovish signals from the Fed. - Investors are rotating from tech stocks to small caps. Rate cut beneficiaries are shifting focus
from large-cap tech companies, which have already experienced gains, to small caps and cyclical
stocks expected to benefit from lower interest rates later. - Small-cap value stocks are seen as attractive. While the Russell 2000 still faces an earnings
recession, experts suggest that small-cap value stocks are more appealing due to a wide valuation
gap compared to large-cap growth stocks.
Rotation From Tech to Small Caps
Small caps’ heightened sensitivity to interest rate expectations stems from their greater reliance on bank financing, unlike large-cap companies that frequently raise funds through stock and bond issuance in capital markets. This dependency makes them more susceptible to changes in borrowing costs.
The current market sentiment suggests that investors are starting to shift their focus from early beneficiaries of rate cuts – mainly large-cap tech – to those expected to gain at a later stage (small caps and cyclical stocks). This is reflected in the strong outperformance of the Russell 2000 over the past five sessions. The index has outperformed the tech-heavy Invesco QQQ Trust (QQQ), which tracks the Nasdaq 100, by 10.4 percentage points, marking the widest five-day relative gain of small caps over tech since November 2016.
David Morrison, senior market analyst at Trade Nation, expressed a bullish interpretation of this rotation. He believes that profit-taking in "overvalued" tech stocks is being channeled into more neglected areas of the U.S. stock market, including small caps. This shift in investment focus, in turn, is expected to create a positive ripple effect across the market, with even "old-school" sectors like the Dow Jones Industrial Average benefiting from the upswing.
Challenges & Potential for Further Upside
While the recent rally has been encouraging, some experts caution against declaring it a sustainable trend. Ayesha Tariq, macroeconomist and founder of Macrovisor, points out that the performance of regional banks, which constitute a substantial portion of the Russell 2000, remains uncertain. These banks are yet to report their earnings, and their financial health remains fragile. Although investment banks have shown strong results driven by trading activities, their net interest margins (NIMs) and wealth management divisions are still facing challenges. For example, Bank of America has reported a 3% decrease in net interest income (NII), and Wells Fargo has seen a 9% decline.
Additionally, the persistence of relatively high yields suggests that regional banks may continue to face unrealized losses on their balance sheets, according to Tariq.
Despite these concerns, Tariq believes that from an investment perspective, small-cap value stocks might be more appealing than their growth counterparts. She suggests that the valuation gap between large-cap growth (as tracked by the iShares S&P 500 Growth ETF (IVW)) and small-cap value stocks (as monitored through the iShares Russell 2000 Value ETF (IWN)) was at its widest since 2000 prior to the recent small-cap rally. This signals potential for further "catch-up" and rotation trade, pushing small-cap value stocks to outperform.
Conclusion
The recent surge in small-cap stocks has been undeniably impressive, fueled by mounting expectations of interest rate cuts. While uncertainties persist, particularly in the regional banking sector, experts are expressing optimism about the potential for further upside, particularly in small-cap value stocks. As investors continue to shift from "overvalued" tech stocks to neglected sectors, the Russell 2000 could see continued gains in the coming period.
However, investors should remain cautious and consider the potential risks associated with this rally. While the Fed has signaled a willingness to cut rates, the path ahead remains uncertain. A change in economic conditions or unexpected events could easily disrupt the current trajectory of the market. Therefore, a balanced approach to investing remains crucial, with diversification and risk management as key considerations.
