Small Caps Just Hit Another Level Not Seen in Nearly Three Years

Small-cap stocks are gaining momentum, showing strong performance in recent sessions. The iShares Russell 2000 ETF (IWM), which tracks the performance of small-cap stocks, closed at its highest point since November 2021 this past Wednesday, marking a 1.7% gain. With a winning streak spanning four sessions, the ETF is now less than 8% away from its all-time high. This recent surge in small-cap stocks reflects broader optimism in the market, driven by several key factors, with the Federal Reserve's actions standing out as a primary catalyst.

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The Federal Reserve (Fed) has played a significant role in the recent strength of small-cap stocks. Last month, the Fed initiated a rate-cutting cycle by reducing interest rates by half a percentage point. Lower interest rates are beneficial for smaller companies, which often rely more heavily on borrowing to fund their operations and growth. With borrowing costs reduced, these companies can expand more affordably, potentially leading to higher profits and better overall performance. As the Fed continues with rate cuts, investors are increasingly confident that the U.S. economy will avoid slipping into a recession, further boosting the prospects for small-cap stocks. These smaller firms tend to be more vulnerable to economic downturns than their large-cap counterparts, so the rate cuts provide a welcome cushion.

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In addition to the Fed's recent rate cuts, Wall Street traders are pricing in the likelihood of further reductions in the coming months. The CME Group’s FedWatch Tool, which tracks market expectations for Federal Reserve policy, indicates a 92% probability of a quarter-point rate cut in November. Additionally, fed funds futures suggest an 86% chance of another 25-basis-point cut in December. These anticipated cuts are further fueling optimism among investors, as lower rates could continue to support small-cap companies by making capital more accessible and affordable.

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Despite their recent performance, small-cap stocks still lag behind large-cap stocks for the year. As of now, the IWM has gained nearly 13% in 2024, while the S&P 500, representing larger companies, has surged 22% over the same period. This disparity has led some market analysts to predict that small-cap stocks may experience a "catch-up trade" as the year progresses, potentially narrowing the gap between their performance and that of large-cap stocks.

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One of the voices supporting this view is JC O’Hara, chief market technician at Roth MKM. In a note released Wednesday, O’Hara suggested that small-cap growth companies could see a rally heading into the year-end. He specifically highlighted several small-cap stocks that appear well-positioned for future success, including Hanesbrands, Dime Community Bancshares, and tech company Insight Enterprises. These companies, which operate in a range of industries, could benefit from the favorable environment created by lower interest rates and the broader economic optimism surrounding small-cap stocks.

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Beyond the Fed's actions, another factor contributing to the positive outlook for small-cap stocks is the upcoming U.S. presidential election. Some analysts believe that the outcome of the election could have a significant impact on the performance of smaller, domestic-focused companies. In particular, the potential for a victory by former President Donald Trump is being viewed as a possible driver of small-cap gains. Eric Johnston, chief equity and macro strategist at Cantor Fitzgerald, recently wrote in a note that the chances of Trump winning the election are higher than what is currently reflected in stock prices.

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According to Johnston, a Trump victory would likely benefit domestic companies in several ways. First, Trump has historically advocated for lower corporate tax rates, which would boost profitability for U.S.-based businesses, including small-cap firms. Second, Trump’s economic policies have included significant spending on infrastructure and other projects, which could provide additional support to smaller companies. Third, Trump’s stance on trade, particularly his imposition of tariffs on Chinese products, could make U.S.-produced goods more competitive, benefiting domestic manufacturers and small businesses. Finally, Trump’s administration could lead to less financial regulation and overall reduction in business regulation, which would further benefit small businesses and their ability to operate efficiently.

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Recent polling data suggests a close race between Trump and Vice President Kamala Harris, with both candidates in a statistical tie heading into the November 5 election. If Trump secures a victory, his policies could create a more favorable environment for small-cap companies, further boosting their potential for growth in the coming years.

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In conclusion, small-cap stocks are enjoying a notable resurgence, buoyed by the Federal Reserve's rate-cutting actions and optimism about future economic conditions. Although they have trailed behind large-cap stocks for much of the year, there is growing speculation that small caps could catch up as the year progresses, particularly if economic conditions remain favorable. Furthermore, the upcoming U.S. presidential election introduces an additional layer of potential upside for small-cap stocks, especially if a Trump victory leads to policies that benefit domestic companies. As such, the outlook for small caps remains positive, with analysts watching closely for continued strength in this segment of the market.

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