The underdogs finally joining the market rally amid Big Tech's dominance
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Hopes for lower interest rates are an invitation for small-cap stocks, typically those with valuations under $2 billion, to join the market rally.
Why it matters: As the market is increasingly concentrated in Big Tech names, investors are looking for places to diversify. Small caps are finally breaking out relative to large caps, in a trend that could be primed to continue.
By the numbers: Small caps tracked by the S&P 600 underperformed large caps by 12% over the last year.
- That's the most extreme dislocation in performance since 2000 on a three-year rolling basis, according to Truist data.
Catch up quick: The underperformance of late was driven by several factors -
- Companies are staying private for longer, and when they do go public, they're bigger, skipping the small-cap phase.
- Higher interest rates are a drag on small companies that are typically more leveraged.
Zoom in: Interest rate cuts, stimulus from the passage of the "one big beautiful bill," decreased macro uncertainty and a reacceleration of the economy could all be catalysts for smaller company earnings growth.
- During rate-cutting cycles, small-cap value stocks, which show lower price-to-earnings ratios, tend to outperform growth stocks, which can have higher prices.
- Quality small caps—companies with strong balance sheets and solid fundamentals— also outperform riskier names when rates fall.
Be smart: Small caps "are a diversifying asset," writes Gregg S. Fisher, founder and portfolio manager at Quent Capital. "But diversifying assets need to perform well sometimes or it doesn't help to hold them."
- He sees small caps breaking out because of valuations.
- Small caps are 40% cheaper than large caps, a discount not seen since the dot com bubble.
- When the bubble burst, "subsequent small-cap returns were among the highest in history," he notes.
Yes, but: Smaller companies are also more susceptible to downturns, since they don't have the same liquidity that larger firms have to weather storms.
- That's in part why Citi notes concerns about labor market weakness or higher for longer inflation as headwinds for small caps.
- RBC is "more open to the idea of near-term (but short-lived)" rotation of leadership into small caps and Bank of America sees the Russell leading "for now."
- Truist upgraded the basket from less attractive to neutral, also cautioning that the rally may revolve around more short-term momentum than long-term fundamentals.
- None of these calls are ringing endorsements.
The bottom line: Wall Street banks like Bank of America and Citi have noted the importance of stock picking as opposed to buying the entire index of small caps.
- This could be a more effective tool as there are systemic risks along with idiosyncratic opportunities within the Russell 2000.
What we're watching: The next jobs report could make or break a September rate cut, which could also make or break the small-cap rally.
