Analysis – Rotation trading turns small caps from dead money to Wall Street darling

By Lewis Krauskopf

NEW YORK (Reuters) – U.S. small-cap stocks are enjoying a long-awaited rally, fueled by expectations of interest rate cuts and improved election prospects for Republican presidential candidate Donald Trump, who supports policies that benefit smaller domestic companies.

The small-company-focused Russell 2000 rose more than 11.5 percent in five days, the index’s biggest gain in such a period since April 2020.

At the same time, technology and growth stocks have faltered, reinforcing the view that small caps have benefited from a migration of this year’s biggest winners to unloved areas of the market. The tech-heavy Nasdaq 100 has fallen 3 percent since last week, including its biggest one-day loss of the year on Wednesday. The S&P 500, widely considered a benchmark for large-cap U.S. stocks, is up 0.2 percent.

“I think the landscape has changed,” said Eric Kuby, chief investment officer at North Star Investment Management Corp, which specializes in small-cap stocks. “I hope this jump last week is just the beginning of what could be a very long, multi-year period where small caps could gain a lot of ground.”

For months, smaller company stocks languished while investors poured their money into the big technology stocks that led the indices for much of 2024. The Russell 2000 is up just 10.5 percent this year despite the recent rebound, while the S&P 500 is up 17 percent and the Nasdaq 100 is up nearly 18 percent.

The outlook changed last week when lower-than-expected inflation numbers raised expectations that the Federal Reserve will cut interest rates in the coming months, which could benefit smaller businesses suffering from increased borrowing costs.

Higher interest rates are a “headwind for small caps,” says Jason Swiatek, head of small and mid-cap equities at Jennison Associates. “On the other hand, this pressure eases somewhat when you move into a rate-cutting cycle.”

The recovery accelerated after a failed assassination attempt over the weekend appeared to boost expectations of a victory for Trump, whose proposals to raise tariffs and cut taxes could benefit smaller businesses.

Small-cap stocks that have rallied since last week’s inflation data were released include biotech company Caribou Biosciences, up 55 percent in that time, homebuilder Hovnanian Enterprises, up more than 30 percent, and insurer Hippo Holdings, up more than 29 percent.

A continued rotation out of the technology sector – whose surge sparked concerns about stretched valuations and drew comparisons to the dot-com bubble two decades ago – could further fuel small-cap strength.

The story goes on

The Russell 2000 last had a total market value of $2.7 trillion, according to LSEG data. That’s less than the individual market values ​​of three stocks – Microsoft, Apple and Nvidia – each with market capitalizations of over $2.9 trillion.

As money flows out of megacap stocks and they look for a new place to invest, it doesn’t take much to give smaller stocks a boost, says Peter Tuz, president of Chase Investment Counsel.

History shows that a sharp rise in small caps is a good sign of their short-term performance. The Russell 2000 gained at least 1 percent in five consecutive sessions last week, something that has happened only four times before, according to Bespoke Investment Group. After those earlier surges, the index posted an average gain of 5.9 percent over the following month, according to Bespoke.

While the S&P 500 has been hitting record highs all year, the Russell 2000 is still about 8% below its 2021 peak, suggesting there may still be room for small caps to move higher.

Retail investors are also buying. Analysts at Vanda Research said inflows into small caps have triggered a “short squeeze,” in which a rising price forces bearish investors to unwind bets against a stock, driving its value even higher.

“We believe retailers continue to have room to chase this trade over the next week or two,” they wrote.

Small-cap investors have been disappointed by strong periods before. Excitement over the prospect of rate cuts sent the Russell 2000 up over 20% between late October and late December 2023, only to fall back earlier this year when no rate cuts materialized.

The reporting season that is now beginning could prove small caps more right. According to LSEG, Russell 2000 companies are expected to report an 18% increase in profits in the second quarter. Megacap growth companies also have the chance to return to the spotlight, as heavyweights Tesla and Alphabet report their figures next week.

Brokerage firm Edward Jones has a “neutral” outlook on small caps and is waiting to see whether the companies can show stronger earnings growth, said Angelo Kourkafas, the firm’s chief investment strategist.

To be more optimistic about the group in the long term, he said, “we would need to see more signs that either earnings are significantly better than expected or that economic activity is picking up.”

(Reporting by Lewis Krauskopf; additional reporting by Suzanne McGee; editing by Ira Iosebashvili and Leslie Adler)