Smaller, lesser-known U.S. stocks have been basking in a lot of attention this week after they out-rallied major benchmarks. What will it take to keep the gains coming?
The initial flourish certainly made the point that stock-market gains don’t have to be driven by Big Tech and huge multinationals.
The Russell 2000, an index of U.S. stocks with an average market capitalization of about US$4.5-billion, gained 11.5 per cent over five trading days through Tuesday – the period that stood out as noteworthy.
“It’s a big move in a short time, and one that we haven’t seen in a few years,” Jill Carey Hall, an equity strategist at Bank of America, said in an interview.
Small-capitalization stocks outperformed the large-cap S&P 500 and the tech-dominated Nasdaq Composite Index, which essentially stagnated over the five-day period. And when tech stocks slumped on Wednesday and Thursday, small caps retreated far less.
This strong performance has raised questions about whether investors are witnessing the start of a dramatic rotation in the stock market, as money flows from the usual suspects toward lesser-known and cheaper stocks that had been struggling until recently.
Prior to the rally, the Russell 2000 Index had trailed the S&P 500 by about 35 percentage points over three years, raising the possibility that a small-cap rebound could develop under the right conditions.
One appeared last week at around the time that the rally began: A reading of U.S. inflation, released July 11, showed that prices in June slowed to 3 per cent, year-over-year, which was better than economists had been expecting.
The reading bolstered confidence that the U.S. Federal Reserve could start to cut its key interest rate in September. This is particularly helpful to small companies because they tend to have more exposure to floating-rate debt and higher borrowing costs.
As well, small companies tend to be more sensitive to economic activity. If rate cuts stimulate the economy, or instill greater optimism, small-cap stocks stand to benefit disproportionately.
Just look what happened in 2020. When stocks hit rock-bottom in March, 2020, after the initial pandemic-related lockdowns and market downturn, small-cap stocks embarked upon a truly impressive relief rally after investors bet that a severe economic meltdown would be avoided.
The iShares Russell 2000 ETF (IWM in New York), an exchange-traded fund that tracks the small-cap index, providing one-stop shopping for investors, rallied 117 per cent over the following 12 months. It beat the S&P 500 by nearly 55 percentage points over this period, according to data from S&P Global Market Intelligence.
Earlier this year, some observers argued that small caps were poised for another period of strong gains.
“As interest rates start to ease and the broader macroeconomic outlook improves, we expect to see more flows into small caps as risk appetite starts to rise once again,” Caroline Moleux, a portfolio manager at AXA Investment Managers, the global investment-management firm, said in a February note.
Is this the start of something big?
U.S. small-cap stocks have at least one key advantage over larger-cap stocks: They’re cheap, with attractive price-to-earnings ratios.
Ms. Hall at Bank of America noted earlier this year that low valuations should help drive 9-per-cent annualized returns for the Russell 2000 over the next decade. That’s a lot better than expected annualized gains of just 2 per cent for expensive large-cap stocks.
But there is no guarantee that this is going to be a smooth ride.
For one thing, there is a lot of competition for investor attention right now, which could thwart an all-out rotation into small-cap stocks.
The artificial-intelligence trade, for example, which has led the stock market for well over a year, still beckons with alluring growth potential. Dividend-paying stocks look attractive with high yields that might not last as interest rates come down. The same goes for bonds.
As well, dampened profits from small-cap companies haven’t recovered as quickly as initially expected. Companies are giving tepid earnings guidance and analysts are reducing their expectations.
Ms. Hall said there are two things that investors are looking at when assessing the rally’s durability: “One, confidence in the Fed cutting, which we are now starting to see. And two, confidence in the profits recovery, and that’s where the jury is still out,” she said.
The good news, then, is that small-cap stocks are hardly priced to perfection, and have plenty of room for further gains. The bad news? After an impressive rally, the downside risk just got bigger.