By Lewis Krauskopf
NEW YORK (Reuters) - U.S. small-cap stocks are having a long-awaited moment, ignited by expectations of interest rate cuts and improving prospects for the election of Republican presidential candidate Donald Trump, a proponent of policies seen as benefiting smaller domestic companies.
The small-company-focused Russell 2000 surged more than 11.5% over five days, the index's biggest gain in such a stretch since April 2020.
At the same time, tech and growth stocks have wobbled, reinforcing the view that small caps have benefited from a rotation out of this year’s biggest winners into unloved areas of the market. The tech-heavy Nasdaq 100 is down 3% since last week, including its biggest one-day drop of the year on Wednesday. The S&P 500, generally considered the benchmark for large-cap U.S. stocks, is up 0.2%.
"I think the narrative has changed," said Eric Kuby, chief investment officer at North Star Investment Management Corp, which specializes in small-cap stocks. "I'm hoping ... this jump over the last week is really just the beginning of what could be a very long, multi-year period of time where small caps could make up a lot of ground."
For months, shares of smaller companies have languished while investors poured money into the massive tech stocks that have led indexes for most of 2024. The Russell 2000 is up only 10.5% this year despite the recent surge, while the S&P 500 has gained 17% and the Nasdaq 100 is up nearly 18%.
The outlook shifted last week, when a softer-than-expected inflation reading boosted expectations the Federal Reserve will cut rates in coming months, a potential boon to smaller companies suffering from elevated borrowing costs.
Higher rates have been a "headwind to small caps," said Jason Swiatek, head of small- and mid-cap equity at Jennison Associates. "On the flip side, as you switch to a rate-cutting cycle, that alleviates a bit of that pressure."
The rally accelerated after a failed assassination attempt over the weekend appeared to increase expectations of a victory by Trump, whose proposals to raise tariffs and lower taxes could benefit smaller companies.
Among the small-cap stocks that have surged since the inflation data last week are biotech firm Caribou Biosciences, up 55% in that time, homebuilder Hovnanian Enterprises, up over 30%, and insurer Hippo Holdings, up over 29%.
An extended rotation out of tech - whose run has sparked concerns over stretched valuations and drawn comparisons to the dotcom bubble two decades ago - could fuel further small-cap strength.
The Russell 2000 last had a total market value of $2.7 trillion, according to LSEG data. That's smaller than the individual market values of three stocks, Microsoft (NASDAQ:MSFT), Apple (NASDAQ:AAPL) and Nvidia (NASDAQ:NVDA), with market caps each over $2.9 trillion.
As money flows "come out of the megacap stocks and they look for a new home, it doesn't take much to get the smaller stocks going," said Peter Tuz, president of Chase Investment Counsel.
History shows that a sharp rally by small caps bodes well for their near-term performance. The Russell 2000 gained at least 1% in five straight sessions over the past week, which has only happened four times before, according to Bespoke Investment Group. Following those prior streaks, the index posted an average gain of 5.9% over the next month, according to Bespoke.
While the S&P 500 has notched record highs all year, the Russell 2000 remains some 8% below its 2021 peak, suggesting small caps may have room to climb.
Retail investors are buying as well. Analysts at Vanda Research said inflows into small caps sparked a “short squeeze,” when a rising price forces bearish investors to unwind bets against a stock, driving it even higher.
“We think there’s scope for retail to continue chasing this trade over the next 1-2 weeks,” they wrote.
Small-cap investors have been disappointed by periods of strength before. Excitement over the prospect of rate cuts sent the Russell 2000 up over 20% between late October and late December of 2023, only for the index to retreat earlier this year when rate cuts did not materialize.
The earnings season now getting underway could provide more justification for small caps, with Russell 2000 companies expected to post an 18% rise in second-quarter earnings, according to LSEG. Megacap growth companies will also have a chance to reclaim the narrative, with heavyweights Tesla (NASDAQ:TSLA) and Alphabet (NASDAQ:GOOGL) reporting next week.
Brokerage firm Edward Jones has a "neutral" outlook on small-caps as it waits to see if companies can show stronger profit growth, said Angelo Kourkafas, senior investment strategist at the firm.
To be more optimistic on the group longer-term, he said, "We would need to see more signs that either earnings are coming in much better than expected or that economic activity is starting to pick up.”