The historic surge in small-cap stocks over the past week is unsustainable, according to analysts at the UK’s Capital Economics, one of Europe’s largest consulting firms, as well as Natixis Investment Managers Solutions, the investment division of France’s Groupe BPCE. Fundstrat, on the other hand, believes this is just the beginning of the rally.
Capital Economics
The small-cap rally that began last week does not appear sustainable, notes John Higgins, the chief markets economist at Capital Economics. He suggests that the outperformance of small caps relative to blue chips will be short-lived.
“A recent surge in the Russell 2000 (which measures the performance of U.S. small-cap stocks) after the U.S. CPI report for June was published last week has prompted claims that we are entering the initial stage of a secular rotation into U.S. small-cap stocks. We are not convinced,” Business Insider quotes Higgins.
He does not see the recent market action as a rotation. That would imply that investors are selling large-cap stocks and using those proceeds to buy small-cap stocks; however, blue chips are still only a few percentage points below all-time highs, Higgins notes.
“We would need to see more evidence of a selloff in ‘big tech’ to be convinced that a rotation into small-cap stocks out of their larger counterparts was well and truly underway,” he stated.
Higgins also disagrees that the rally in small-cap stocks is driven by rising hopes for an imminent reduction in U.S. interest rates. When the Fed cut rates in the mid-1990s, in 2009, and in 2019, small caps underperformed blue chips, he recalled.
“We anticipate a bubble in the stock market continuing to inflate amid hype around AI, like one did in the second half of the 1990s around the internet. Back then, small-cap stocks generally underperformed their large-cap peers until mid-1999,” Higgins noted.
He highlights that earnings remain the most important factor driving stock market dynamics, and he is yet to see signs that small-cap stocks will outperform blue chips on earnings growth. “It remains to be seen whether big-tech firms will fail in general to continue to beat analysts’ lofty expectations for their earnings,” he said. Earnings season for the mega-cap tech companies is set to kick off next week with second-quarter results from Tesla and Alphabet.
Natixis
Natixis Investment Managers Solutions is “looking for the right opportunity to go into smalls, [but] not really thinking to chase this rally right now,” Garrett Melson, a portfolio strategist at the investment firm, told Barron’s. He believes that, in the next couple of months, it is better to “have a little bit more concentration around the growth picture [of tech stocks].” He recalled that small-cap stocks rose before the Fed started cutting interest rates in 1995 but lost all the gains when economic growth began to slow down, the rise in small-cap stocks becoming sustainable only when confidence in stable economic growth emerged. “That’s what we’re waiting for,” Melson stated.
Other opinions
Whereas Higgins from Capital Economics is betting against further growth in small-cap stocks and Melson from Natixis has his doubts, Fundstrat’s Tom Lee told clients this week that the small-cap rally is just beginning, predicting a 40% rise over the next 10 weeks.
When the Russell 2000 rose about 30% in the last few months of last year, large-cap stocks also lost ground, Lee noted. Considering how oversold small-cap stocks are now, he suggests that this time the rotation could be even more significant.
Strong financial performance by small companies, together with positive financial forecasts, could strengthen the case for doubling down on the small-cap sector this year, according to Wolfe Research Chief Investment Strategist Chris Senyek. Moreover, headwinds for big tech companies, such as disappointment with AI adoption or concerns around capital spending, could mean trouble for Big Tech shares.
It is possible that small caps, which have recorded the biggest-ever outperformance versus the Nasdaq Composite in the past five sessions, have already factored in all the positive news. Because of that, Dennis DeBusschere from 22V Research believes that the pace of small-cap returns is likely to slow moving forward.
The rally in the Russell 2000
The Russell 2000 index comprises 2000 small-cap U.S. stocks with an average market capitalization of around $4.5 billion. On Tuesday, July 16, it hit its highest mark since early January 2022. The next day, amid sharp losses in large-cap tech stocks, the Russell 2000 lost 1.1%, which brought to an end a historic streak of five straight sessions with gains of more than 1%.
