S&P 500 Stocks Are Underperforming Small-Cap Stocks. Bond Yields May Hold the Key

Small-cap stocks have seen a notable surge this month as investors consider the potential impact of President-elect Donald Trump's upcoming administration on economic growth, inflation, and interest rates.

‍

On Monday, the Russell 2000 Index, which represents U.S. small-cap equities, climbed 1.5%, significantly outpacing the S&P 500, which only saw a modest 0.1% gain but still managed to reach a new record high. Small-cap stocks, which had already been outperforming the S&P 500 over the past week, continued this trend.

‍

According to Louis Navellier, Chief Investment Officer at Navellier & Associates, market momentum remains robust. Although valuations are becoming stretched relative to historical levels, Navellier suggests that investors are bidding up underperforming sectors, which is reflected in the Russell 2000’s substantial outperformance over the S&P 500. He attributed this momentum to a “fear of missing out” among investors eager to capitalize on stock market gains.

‍

Analysts at Jefferies also weighed in, noting that they were interested in understanding whether small-cap stocks would maintain their upward trajectory following the election results. They pointed out that interest rates would play a critical role, especially as long-term Treasury yields have fallen. Last week, small-cap stocks surged as yields on longer-term Treasury bonds, which had initially jumped following Trump’s victory, started to retreat.

‍

This yield spike was primarily driven by investor concerns that Trump’s tariff policies and potential fiscal spending could increase inflation and add to the federal deficit. However, the 10-year Treasury yield, a key rate that influences stock valuations, ended the week lower as market participants evaluated Federal Reserve Chair Jerome Powell’s recent comments following the Fed’s November 7 rate decision.

‍

The Jefferies analysts highlighted that Powell didn’t make a firm commitment to lower rates quickly, which led some on Wall Street to adjust their rate cut expectations for 2025. This shift, they noted, would likely keep a spotlight on upcoming inflation data over the next several months. Despite the uncertainty around future rate cuts, small-cap stocks continued to rally, showing resilience in the face of fluctuating interest rate expectations.

‍

The 10-year Treasury yield, which finished at 4.307% on Friday after a 5.4 basis point drop last week, ended a seven-week streak of rising yields, according to Dow Jones Market Data. The 2-year Treasury yield, on the other hand, saw a slight increase, closing at 4.253% last week after a rise of 5.2 basis points.

‍

Before the election, Treasury yields had been on the rise due to unexpectedly strong economic data and betting markets indicating a higher chance of a Trump victory, according to John Madziyire, a senior portfolio manager and head of U.S. Treasuries and TIPS at Vanguard Group. Following the election, yields initially spiked in what Madziyire described as a “knee-jerk reaction.”

‍

However, he noted that it made sense for the market to pull back afterward. According to Madziyire, for yields to rise significantly from current levels, there would need to be a strong belief that Trump’s proposed policies, including tariffs, would actually come to fruition.

‍

Amid this backdrop, the Russell 2000 has climbed almost 11% so far this month, easily outperforming the S&P 500’s 5.2% increase, as reported by FactSet. Jefferies analysts believe that while lower interest rates would further fuel the rally, the market might be experiencing a structural shift in favor of small-cap stocks for the intermediate term. Their research revealed that when the Russell 2000 outpaces the S&P 500 significantly, small-cap performance tends to remain robust. They noted that the Russell 2000’s five-day return as of November 6 marked an event with over three standard deviations, underscoring the strength of the recent rally.

‍

Using data dating back to 1980, Jefferies analysts examined the spread in five-day returns for the Russell 2000 compared to the S&P 500 and found that, historically, the small-cap index has delivered an average return of nearly 7% over the following six months and a 14% gain over the next 12 months. This trend suggests that small-cap stocks may continue to provide strong returns in the near future, even as interest rate dynamics remain uncertain.

‍

The broader U.S. stock market also saw gains on Monday. The S&P 500 closed above 6,000 for the first time, while the Dow Jones Industrial Average climbed 0.7%, and the Nasdaq Composite edged up 0.1%. The overall rally in equities reflects optimism over the potential for stronger economic growth driven by anticipated pro-growth policies from the incoming administration.

‍

Brent Schutte, Chief Investment Officer at Northwestern Mutual Wealth Management, stated in a Monday note that small- and mid-cap stocks in the U.S. appear to be undervalued compared to large-cap stocks. He explained that, historically, small- and mid-cap stocks have been cheaper, making them attractive to investors seeking broader economic exposure in a potentially expanding economy under Trump's policies.

‍

In summary, small-cap stocks have experienced a substantial rally fueled by expectations of favorable economic policies under the incoming administration, along with recent declines in long-term Treasury yields. Although uncertainties remain regarding future interest rate changes, the structural factors driving small-cap performance appear robust, with potential for continued outperformance relative to larger-cap counterparts in the months ahead.

‍