As July's Rotation Rally Fizzles, Small-Cap Stocks Are Down, but Not Out

After a strong July performance, small-cap stocks have seen their rally lose steam, underperforming relative to their large-cap counterparts. However, investors shouldn't write them off just yet.

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In July, the Russell 2000, a key small-cap index, outpaced both the S&P 500 and the Nasdaq Composite by the widest margin in decades. But the momentum has waned in August, with the Russell 2000 dropping nearly 5% since the start of the month, even though it showed signs of recovery later in the week. Despite this recent dip, the index is still up 4.6% since the beginning of the third quarter, compared to a 1.7% gain for the S&P 500.

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For those who invested in small caps in July, the recent downturn might feel like a letdown. This scenario mirrors earlier in the year when small-cap stocks had a brief period of outperformance in November and December, only to stagnate as investors adjusted their expectations regarding potential Federal Reserve interest rate cuts.

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Yet, despite these setbacks, some analysts on Wall Street remain optimistic that small-cap stocks could reclaim their position as market leaders later this year, possibly maintaining that status for an extended period.

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The argument in favor of small caps is supported by attractive valuations and improving fundamentals. Strategists and portfolio managers point out that small-cap stocks stand to benefit significantly, particularly if the Federal Reserve finally follows through with the anticipated rate cuts.

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A key reason for this optimism is the expectation of robust earnings growth for small-cap companies. After a prolonged period of stagnation, analysts foresee small-cap earnings growth outpacing that of large-cap companies through 2025. While short-term market movements are often driven by sentiment and positioning, fundamentals like earnings growth tend to prevail over time, as noted by Josh Jamner, an investment strategy analyst at ClearBridge Investments.

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Jamner believes that small caps have the potential to outperform in the medium term, which he defines as the next 12 to 18 months. However, he also acknowledges that much depends on whether the Federal Reserve can successfully navigate the economy away from a recession. Jamner remains hopeful, predicting a "soft landing" scenario where economic growth decelerates only modestly.

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Another reason to consider investing in small caps is their historical performance following Federal Reserve rate cuts. A June analysis by Jefferies revealed that, on average, small-cap stocks gained 27% in the 12 months following a rate cut, compared to a 16% gain for large caps. This analysis, which examined data since 1950, suggests that small caps tend to benefit more when interest rates start to decline.

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Sandy Villere, a portfolio manager at Villere & Co., a New Orleans-based investment adviser managing $1.8 billion in equity and fixed-income strategies, agrees that small caps remain undervalued, even after their July rally. Villere points out that anything reinforcing the notion of a soft landing for the U.S. economy, as opposed to a recession, should disproportionately benefit small-cap stocks.

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Villere also notes that the recent fluctuations between small-cap outperformance in July and the early August pullback reflect investors' attempts to navigate between the possibilities of a hard landing versus a soft landing, or recession versus no recession scenarios. Despite the recent setbacks, small-cap stocks continue to trade at a steep discount compared to their valuations over the past decade, while large caps remain at a premium. Villere adds that small caps have historically outperformed over the long term, even if they have lagged recently.

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However, not everyone shares this optimism. Some analysts are skeptical about small caps' ability to outperform large-cap stocks, particularly the Big Tech giants like Nvidia Corp. Before jumping in, small-cap investors might want to consider what happened after the Federal Reserve cut rates in 1995, suggests Garrett Melson, a portfolio strategist at Natixis Investment Managers Solutions.

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That period, often compared to the current economic environment, saw small caps rally strongly ahead of the first rate cut. But once rates started coming down, large caps quickly took the lead. Melson believes a similar dynamic could play out today. Instead of shifting back to an accommodative monetary policy, the Fed is expected to return interest rates to a "neutral" level, meaning any boost small caps get from rate cuts could be limited.

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Melson also highlights other reasons for caution. For instance, the entire market capitalization of the Russell 2000 is roughly equivalent to that of Apple Inc. This means there is less room for capital to flow into small caps without significantly driving up prices. "Their valuations might be cheap, but they're cheap for a reason," Melson warns.

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As of Friday's close, the Russell 2000 had gained 2.9% for the week, ending at 2,141.92. In comparison, the S&P 500 rose 3.9% to close at 5,554.25, the Nasdaq Composite increased by 5.3% to finish at 17,631.72, and the Dow Jones Industrial Average added 96.70 points, or 0.2%, to end at 40,659.76.

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