Small-cap stocks are experiencing a surge not seen since the early days of the pandemic, fueled by a dramatic shift in investor sentiment towards earlier interest rate cuts by the Federal Reserve. This newfound optimism stands in stark contrast to the sluggish performance of the small-cap Russell 2000 Index earlier this year, highlighting a potential turning point in the market.
Key Takeaways:
- The Russell 2000 Index has skyrocketed 12% in the past five trading sessions, significantly outperforming the broader market.
- This rally coincides with a decline in inflation expectations and a subsequent drop in Treasury yields.
- Historically high short positions in small caps by hedge funds further fueled the upward momentum.
- Improved earnings forecasts for small companies and a bullish options positioning suggest a potential sustained rally.
- However, some analysts warn of overheating and recommend waiting for confirmation from strong earnings data.
Small Caps Outperform in Dramatic Shift
The slumbering giant has awakened. The Russell 2000 Index, a barometer for small-capitalization stocks, has witnessed a meteoric rise in recent weeks, surging 12% over the past five days. This stellar performance dwarfs the gains of the broader market, with the S&P 500 Index climbing a mere 1.6% and the technology-laden Nasdaq 100 Index dipping slightly in the same period.
This dramatic shift can be attributed to a confluence of factors. Primarily, it coincides with a noticeable decline in inflation expectations. The latest consumer price index (CPI) report triggered a plunge in the two-year Treasury yield, prompting investors to believe the Federal Reserve might cut interest rates sooner than anticipated.
Small Caps: Particularly Vulnerable to Interest Rates
Smaller companies are inherently more susceptible to fluctuations in borrowing costs compared to their large-cap counterparts. This is due to their typically heavier debt loads. As a result, the prospect of a dovish Fed stance from hawkish has proven to be a boon for small-cap stocks.
Short Squeeze Ignites Rally
Adding fuel to the fire was the significant short positioning in small caps by hedge funds. Data from S3 Partners reveals that a staggering 25% of the $68 billion iShares Russell 2000 ETF’s free float was held short by these institutions. When the lower-than-expected inflation data emerged, these funds were caught off guard, leading to a scramble to cover their short positions, further amplifying the upward momentum.
Is the Rally Sustainable?
The question on every investor’s mind is whether this small-cap rally has legs. While the group has experienced several false starts in recent years due to fluctuating Fed rate cut expectations, the current environment presents compelling reasons for optimism.
Firstly, small-cap valuations have plummeted to historically attractive levels. This inherent value proposition becomes even more enticing as the market embraces a risk-on approach. Despite the recent surge, the Russell 2000 remains significantly behind the S&P 500 in terms of year-to-date performance, with a gain of 12% compared to 19%.
Earnings Outlook Brightens for Small Caps
Adding to the bullish narrative is the improving earnings outlook for small companies. According to an analysis by RBC Capital Markets, consensus forecasts suggest a robust recovery in late 2024 for both revenue and net income growth for the Russell 2000. This trajectory is expected to bring it closer to the performance of the S&P 500. Notably, the rate at which analysts are revising upwards their earnings estimates for small caps has also begun to catch up with the larger benchmark.
Investor Sentiment Shifts Bullish
Options market activity further validates the growing bullish sentiment towards small caps. The implied volatility for one-month options on the iShares Russell 2000 ETF is at its highest level since April. This indicates that investors are prepared to pay more to speculate on significant price movements in the index. Additionally, the premium for put options, which provide protection against a decline, has shrunk to its lowest point since December, reflecting a reduced fear of a downturn.
A Word of Caution
While the current scenario paints a rosy picture for small caps, some market veterans urge caution. The Russell 2000 is currently exhibiting signs of being “overbought,” a technical indicator that often precedes a reversal. This suggests that the index might be due for a correction in the near term.
Analysts who subscribe to this view advocate for a wait-and-see approach until a more definitive confirmation arrives in the form of strong earnings reports from small companies.
