This quarter, the small-cap-tracking Russell 2000 index has outperformed the S&P 500, which measures the performance of the largest publicly traded companies in the U.S. This comes amid rising market expectations for Fed rate cuts. Since last summer, interest rates have been at their highest level in 22 years, notes MarketWatch.
Details
The Russell 2000 has added about 5% since July 1, versus a gain of a little over 2% for the S&P 500 in the same period. The outperformance has held up even though small caps took a worse beating than large caps in September, notes MarketWatch.
“Small caps got a lift when the Fed definitively signaled a move to easier policy” at the Jackson Hole Economic Symposium in late August, Liz Ann Sonders, the chief investment strategist at Charles Schwab, said in an interview with MarketWatch.
Sonders added that small companies often perform well in easing cycles, while this is typically more pronounced when the Fed cuts rates to combat a recession and investors prepare for an economic recovery.
“But we’re not in a recession,” Sonders underscored. “[Despite the slowdown,] the economy is doing pretty well.”
The recent rally in small-cap stocks “stalled a little bit” after traders adjusted their expectations regarding the scope of potential rate cuts, says the Charles Schwab strategist. More traders now expect the Fed to start with a cut of 25 instead of 50 basis points, according to the latest Reuters survey. This, according to Sonders, “could trigger some profit-taking in small caps.”
She cautions that the small-cap universe is “huge” and not “monolithic,” with both high- and low-quality companies in the Russell 2000. Meanwhile, the S&P Small Cap 600 index considers profitability when adding companies, so investors may want to use it as a base when screening for ideas, Sonders concluded.
Context
Investors are expecting the Fed to cut rates on Wednesday, September 18, after it wraps up its latest FOMC meeting. A rate cut could provide a significant boost to small-cap stocks, since smaller firms are more leveraged and sensitive to borrowing costs than large firms, points out Sean Gallagher, the global head of the small-cap equity platform at Lazard. He believes small caps may be poised for a big rally in the next 6-12 months, with gains of up to 30-50%, driven by rate cuts. The main risk is that the Fed falls behind the curve in addressing a weakening economy, Gallagher notes.
