The small cap play

Recent outperformance

Small-capitalization (small-cap) stocks became the big winners in the market this week, after lagging larger capitalizations all year. The recent soar is at a pace not seen since the pandemic amid upcoming rate cut bets by the Federal Reserve (Fed) in a risk-on signal for the investment community.

Over the first half of July, the small-cap Russell 2000 Index was up 6.84%, while the S&P 500 Index was up 3.18%, and the technology-heavy Nasdaq 100 Index was up 3.60%[1].

A market trend potentially for a while

The largest exchange-traded fund tracking the Russell 2000 Index posted the second-biggest inflow among equity ETFs last week. Some data suggest this rally could continue as traders who were betting against small-cap stocks got caught out and need to close their positions.

Why the recent turnaround + Outlook

Typically, smaller capitalization companies are sensitive to high borrowing costs because they carry heavier debt loads than big capitalizations. This aggressive rally appears to have been sparked by progress in the latest inflation data, particularly last week’s consumer price index (CPI) which sent the two-year Treasury yield plunging and caused traders to revise their expectations for when the Federal Reserve will cut interest rates.

Attractive valuations and a diversification play

Small-caps stocks have seen several false starts in the past two years amid fluctuating expectations for when the Fed will cut rates. As a result, their valuations have dropped to historic lows and now look attractive targets in a risk-on[2] context. Granted investors must remain cautiously optimistic about the small-cap rally, diversification remains key in the context of well-constructed portfolio.

[1] Index data as of July 15, 2024. Investors may not invest directly in an index. Index returns do not reflect any management fees, transaction costs or expenses.

[2] When risk is perceived to be low, investors tend to engage in higher-risk investments. Investors tend to gravitate toward lower-risk investments when risk is perceived to be high.