Small-Cap Stocks Surge Amid Shifting Tides: A Potential Resurgence in the Making

The U.S. small-cap stock market has been the center of attention lately, with the Russell 2000 index surging over 11.5% in just five days. This remarkable performance has been fueled by a combination of factors, including expectations of interest rate cuts and the potential impact of a Republican presidential candidate's policies on smaller domestic companies.

Unlocking the Potential of Small-Cap Stocks: A Shift in the Narrative

The Changing Landscape: From Tech Dominance to Small-Cap Resurgence

The recent surge in small-cap stocks has come at a time when tech and growth stocks have shown signs of weakness. The tech-heavy Nasdaq 100 index has declined by 3% since last week, including its biggest one-day drop of the year on Wednesday. In contrast, the S&P 500, which is generally considered the benchmark for large-cap U.S. stocks, has managed to eke out a 0.2% gain. This shift in market dynamics has reinforced the view that small-cap stocks have benefited from a rotation out of the year's biggest winners, as investors seek opportunities in less-explored areas of the market.

The Allure of Small-Cap Stocks: Potential for Long-Term Outperformance

Eric Kuby, the chief investment officer at North Star Investment Management Corp, which specializes in small-cap stocks, believes that the narrative has changed, and this recent surge could be the beginning of a prolonged period of outperformance for small-cap stocks. He expressed his optimism, stating, "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."

The Impact of Interest Rate Expectations: A Potential Boon for Small-Cap Firms

The outlook for small-cap stocks has shifted in recent weeks, with a softer-than-expected inflation reading boosting expectations that the Federal Reserve will cut interest rates in the coming months. This potential shift in monetary policy could be a significant boon for smaller companies that have been grappling with elevated borrowing costs. Jason Swiatek, the head of small- and mid-cap equity at Jennison Associates, noted that higher rates have been a "headwind to small caps," and that the switch to a rate-cutting cycle could "alleviate a bit of that pressure."

The Trump Factor: Potential Policy Shifts and Their Impact on Small-Cap Stocks

The rally in small-cap stocks has also been fueled by increased expectations of a victory by Republican presidential candidate Donald Trump. Trump's proposals to raise tariffs and lower taxes could potentially benefit smaller companies, as they are often more reliant on domestic markets and may be more sensitive to changes in tax policies. The failed assassination attempt over the weekend appeared to further bolster these expectations, contributing to the accelerated rally in small-cap stocks.

The Rotation Out of Tech: Implications for Small-Cap Strength

An extended rotation out of the tech sector, whose run has sparked concerns over stretched valuations and drawn comparisons to the dotcom bubble two decades ago, could fuel further small-cap strength. As money flows out of the megacap stocks, investors may seek new homes for their capital, and the smaller stocks could be the beneficiaries of this shift. Peter Tuz, the president of Chase Investment Counsel, noted that "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."

The Retail Investor Factor: A Short Squeeze Fueling Small-Cap Gains

Retail investors have also been actively participating in the small-cap rally, with analysts at Vanda Research noting that inflows into small caps have sparked a "short squeeze." This phenomenon occurs when a rising price forces bearish investors to unwind their bets against a stock, further driving the price higher. The analysts believe that there is "scope for retail to continue chasing this trade over the next 1-2 weeks."

The Earnings Season Ahead: A Potential Catalyst for Small-Cap Outperformance

The upcoming earnings season could provide further justification for the small-cap rally, as Russell 2000 companies are expected to post an 18% rise in second-quarter earnings, according to LSEG data. This could help solidify the case for small-cap outperformance, especially as megacap growth companies, such as Tesla and Alphabet, report their results in the coming weeks.

The Cautious Outlook: Waiting for Stronger Profit Growth and Economic Activity

Despite the recent surge, some market participants remain cautious on small-cap stocks. Angelo Kourkafas, the senior investment strategist at Edward Jones, has a "neutral" outlook on the group, stating that the firm 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" to become more optimistic on the small-cap segment in the longer term.