What Makes Small Caps the 'Most Compelling Investment Case' at the Moment

Futures point to a strong start for equities this week, with the S&P 500 nearing a record high.

‍

Despite the current calm, recent sessions have been marked by intense activity as analysts detect a potential shift in stock-market sentiment.

‍

Greg Boutle, head of U.S. equity and derivative strategy at BNP Paribas, notes that last Thursday’s consumer-price index report for June was softer than expected, leading to a drop in Treasury yields and sparking a significant rally in previously neglected parts of the market.

‍

Small-cap stocks, in particular, gained favor that day, while Big Tech stocks faced heavy selling.

‍

Although this trend partially reversed on Friday, investors are now questioning whether the newfound interest in small caps indicates a longer upward trend for the sector.

‍

Tom Lee, head of research at Fundstrat, believes it does. He argues that small caps, tracked by the iShares Russell 2000 ETF, present the “most compelling near-term investment case.” Lee predicts small caps could rise by 50% in 2024, noting that the sector has only gained 6% so far, suggesting significant room for growth. “The surprisingly low June CPI, in our view, is giving the ‘green light’ for small caps to continue to rally,” he says.

‍

Lee provides five reasons for his optimism.

‍

Firstly, the probability of a 25-basis-point interest-rate cut by the Federal Reserve in September has surged to around 95%. Smaller companies are more sensitive to borrowing costs, so any Fed cut would be beneficial, assuming it’s not due to a severe economic slowdown.

‍

Secondly, Lee points out that the IWM (iShares Russell 2000 ETF) surged about 27% from October to December last year when the Fed was perceived to be on pause. “With an actual Fed cut, we foresee a larger and longer rally.”

‍

Thirdly, sentiment towards regional banks is improving. Regional banks represent a significant portion of the financial-services sector within the IWM, and the SPDR S&P Regional Banking ETF has recently broken out to the upside.

‍

Fourthly, Lee asserts that investor inflation expectations are currently too high and that, when these expectations lower, it will provide “fuel for small caps.”

‍

Finally, there’s the relationship between small-cap debt and stocks. The yield, or risk premium, demanded by investors to hold CCC-rated paper compared to BB-rated paper of larger companies has been narrowing. This contraction of the “quality spread,” indicating greater investor confidence in small caps, typically results in small-cap stocks outperforming their larger counterparts. However, this outperformance has yet to occur.

‍

“In summary, we see the conditions for a strong rally in IWM. And Mark Newton, head of technical strategy, believes a confirming ‘breakout’ of small caps could happen this week,” Lee concludes.

‍

U.S. stock-index futures ES00 YM00 NQ00 are up, with benchmark Treasury yields slightly rising, as markets bet on Donald Trump’s increased likelihood of winning the November presidential election following the apparent assassination attempt in Pennsylvania over the weekend. The dollar index remains stable, while oil prices CL are up marginally, and gold GC00 is trading around $2,408 an ounce.

‍