Stocks in Small-cap Companies Gain Some Traction Following the Pause in the Big Tech Rally. How Long Can They Keep It Up?

U.S. small-cap stocks seem ready for a strong performance in the latter half of 2024 following a rather slow start to the year. This week saw a notable shift as investors moved away from megacap technology stocks in favor of undervalued sectors, spurred by new data indicating cooling inflation and raising hopes for Federal Reserve interest rate cuts this fall.

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Market strategists informed MarketWatch that the uncommon outperformance of small-cap stocks compared to the broader market likely reflects a natural shift into this lagging sector. Investors are seeking bargains after the S&P 500 reached record highs, rather than betting on further rate cuts this year or a robust U.S. economy.

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The Russell 2000 index, a benchmark for small-cap stocks, rose by 6% this week, outpacing the S&P 500 by the largest margin since November 2021. This was also the biggest one-week point and percentage gain for the Russell 2000 since November, according to Dow Jones Market Data. On Friday, the index closed at its highest level since January 2022, having hit a new 52-week high earlier in the day.

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Steve Sosnick, chief strategist at Interactive Brokers, remarked, "The rally might signal the start of a breakout for small caps. Anytime you’re at 52-week highs, you have to respect that." He noted that small-cap stocks have struggled to maintain a rally over the past year but are now in a better position technically.

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Earlier this year, some investors anticipated a significant comeback for small caps in 2024, hoping for lower interest rates and a soft landing for the economy. Despite this, the Russell 2000 has only gained 6% year-to-date, compared to the S&P 500’s 17.7% rise and the Nasdaq Composite’s 22.6% increase, according to data.

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Optimism for U.S. stocks this week largely stemmed from expectations that the Federal Reserve is preparing to cut rates, potentially as soon as September. June's consumer-price index showed a decrease for the first time since the early pandemic days in 2020, with year-over-year inflation slowing to 3%. The core inflation rate, which excludes volatile energy and food costs, rose by just 0.1% from May, bringing the annual core rate down to 3.3%.

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Federal Reserve Chair Jerome Powell stated earlier this week that he would not signal the timing of future rate actions, but cautioned that reducing policy restraint too late or too little could weaken economic activity and employment. San Francisco Fed President Mary Daly also indicated that current U.S. economic data support a rate cut.

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Positive economic data and dovish comments from Fed officials have led fed-funds futures traders to price in nearly a 90% chance of a quarter-point rate cut in September, according to the CME FedWatch Tool.

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Small-cap stocks are typically more sensitive to interest rates than their larger counterparts. They often suffer when rates are expected to remain high for longer and recover on signs that the central bank's monetary-tightening cycle might be ending.

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However, the recent outperformance of small-cap stocks was driven more by "momentum" and a broadening of the stock rally rather than significant macroeconomic changes, Sosnick told MarketWatch. "A 25-basis-point rate cut here and there doesn’t necessarily move the needle for any set of stocks, let alone small caps," he said. "We haven’t seen anything that leads us to believe that the economy is growing so strongly that a lot of the unpopular companies in the Russell 2000 will, in fact, turn profitable."

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Quincy Krosby, chief global strategist at LPL Financial, said the Russell 2000 is seen as an important indicator for potential interest-rate easing as well as a gauge for economic conditions. Stocks in the small-cap and midcap sectors tend to sell off at the slightest hint of a significant economic slowdown, despite their attractive valuations.

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Krosby noted that the slight deflation in the CPI report contrasts with concerns that the economy is cooling faster and that the labor market is slowing. Consequently, she questioned whether such a dramatic shift towards small-cap and midcap stocks is justified.

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Most financial-market investors expect that the central bank could achieve a soft landing after meeting its inflation mandate, preferring rate cuts due to declining inflation rather than a deteriorating labor market. However, this scenario is now more uncertain as the economy slows more rapidly, Krosby said.

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U.S. stocks ended the week higher on Friday. The S&P 500 rose by 0.9%, the Nasdaq gained 0.3%, and the Dow Jones Industrial Average climbed 1.6%, according to FactSet data.

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