Small-cap stocks are gaining momentum this quarter, outpacing the S&P 500 as investors position themselves for potential interest rate cuts from the Federal Reserve. With rising optimism that the central bank might pivot to a more accommodative stance, traders are increasingly betting on smaller companies to deliver outsized returns in a shifting economic landscape. This renewed interest in small caps signals a broader market sentiment that favors risk-taking, reflecting hopes of a softer monetary policy in the near future.
According to Liz Ann Sonders, Chief Investment Strategist at Charles Schwab, small caps tend to perform well in a rate-cutting environment, especially when the Fed cuts rates to combat a recession and investors position themselves for an economic recovery. However, she noted that “we’re not in a recession,” and despite some slowing, “the economy is doing pretty well.”
Market Movements: Small Caps Versus Large Caps
The Russell 2000 index (RUT), which serves as a key gauge of U.S. small-cap stocks, has risen by 4% this quarter. However, it has slid 4% in September through Thursday, according to FactSet data. Meanwhile, the S&P 500 (SPX), which tracks U.S. large-cap stocks, has seen smaller gains of 2.5% this quarter but is still outperforming small caps significantly this year.
Market participants are anticipating that the Federal Reserve will announce the start of a rate-cutting cycle after its policy meeting concludes on Wednesday. The expectation is that the Fed will reduce its benchmark rate from the current elevated levels held since July 2023, a period marked by aggressive rate hikes to counter U.S. inflation that peaked in 2022 and has since moderated closer to the Fed’s 2% target.
Fed’s Rate Decision and Market Expectations
Traders in the federal-funds futures market currently see a 69% probability of a 0.25 percentage point rate cut to a range of 5% to 5.25%, based on data from the CME FedWatch Tool. However, Sonders warns that investors hoping for a more substantial rate cut should “be careful what you wish for,” as more profound reductions often signal deeper economic problems, such as a recession or financial crisis.
The recent surge in small-cap stocks, generally seen as riskier than their large-cap counterparts, has “stalled a little bit” due to the market’s recalibration of expected rate cuts—from a half-point reduction to a quarter-point cut. This shift, according to Sonders, has triggered some profit-taking in small caps because these stocks tend to benefit more from lower rates compared to larger companies.
Strategy Focus: High-Quality Small Caps
While small-cap stocks may appear attractive in a lower rate environment, Sonders advises caution, pointing out that the sector is far from uniform. The Russell 2000, for example, encompasses a broad range of companies with varying levels of performance, often aligned with their quality metrics. “The economy is slowing, not about to accelerate,” Sonders says. Therefore, she suggests that investors looking for opportunities in small-cap stocks should “stay up in quality.”
The S&P Small Cap 600 index (SML), which typically includes higher-quality stocks than the Russell 2000 due to its “profitability filter,” may provide a more reliable base for identifying potential investment ideas, Sonders adds.
Performance Snapshot: Small Caps vs. Broad Market
On Thursday, small-cap stocks outperformed the broader market, with both the Russell 2000 and the S&P Small Cap 600 climbing 1.2%, compared to a 0.7% increase for the S&P 500. U.S. stocks broadly advanced on the day, with the Dow Jones Industrial Average (DJIA) rising 0.6% and the Nasdaq Composite (COMP) gaining 1%.
Year-to-date in 2024, the S&P 500 is up 17.3%, outpacing the Russell 2000’s gain of just over 5%, despite some volatility in September. The S&P 500 has fallen 0.9% this month, while the Russell 2000 has slumped 4%, according to FactSet data.
Key Takeaways for Traders
- Interest Rate Expectations: A potential rate cut by the Fed could provide a tailwind for small-cap stocks, but traders should manage expectations as the size of the cut remains uncertain.
- Focus on Quality: With economic growth slowing, investors are advised to focus on higher-quality small-cap stocks, which may offer better resilience.
- Market Dynamics: Recent market movements suggest some profit-taking in small caps, particularly as the market recalibrates its expectations for rate cuts.
Conclusion
As the Fed prepares to clarify its monetary policy stance, traders and investors should remain vigilant. While small-cap stocks could benefit from an easing cycle, the broader economic context and the quality of individual stocks should guide investment decisions. With uncertainty around the size and timing of future rate cuts, market participants should brace for potential volatility and continue to favor high-quality names in the small-cap space.
