It has outperformed all others over the past month.
Investors are eyeing the first of 2025 this coming September and their expectations were buoyed by comments from Fed Chair Jerome Powell at the recent Economic Symposium.
In anticipation of the Federal Open Market Committee () likely reducing the federal funds rate at its September 16-17 meeting, one asset class has outperformed all others – small caps.
Small cap stocks, as measured by the Russell 2000 index, have risen more than 5% over the past month, beating the S&P 500, Nasdaq Composite, the S&P 400 midcap index, and the over that stretch.
The reason is that small caps typically benefit the most from rate cuts. That’s because small caps need to invest in their growth but typically don’t have the cash and resources on hand like larger companies. So, they need to borrow, but when rates are higher, it makes borrowing a deterrent. But when rates are lowering, it improves the likelihood of borrowing to invest in their future growth.
Last year, when the Fed cut interest rates in the fall, the Russell 2000 surged some 16% from early September to December – nearing an all-time high. Since then, the Russell 2000 has lagged the other indexes, as rate cuts stopped, inflation rose, and the economy slowed, making conditions more difficult for smaller companies. But now small caps seem poised for another jump.
“When it comes to small-cap performance, interest rate cuts usually spark a rally. In these situations, the Russell 2000 often outperforms the S&P 500, at least for the first few months,” John Murillo, chief business officer of B2BROKER, a global fintech solutions provider for financial institutions. “This is largely due to lower borrowing costs and the fact that small-cap companies tend to rely more on floating-rate debt.”
Small Caps Are Primed to Outperform
Murillo expects to see the Russell 2000 surge by another 5% to 7% through the end of the third quarter. It will be fueled by not only lower rates, but also favorable valuations compared to mostly overvalued large cap stocks.
The Buffett Indicator, a key gauge of large-cap valuations, is at an all-time high. Further, the Shiller P/E ratio, which looks at large-cap valuations over a 10-year inflation adjusted period, is at 39, nearing the levels it reached in 2021 before the crash.
According to Royce Investment Partners, small-caps valuations are near a 25-year low relative to large-cap stocks, based on their preferred index valuation metric, EV/EBIT or enterprise value over earnings before interest and taxes.
“We think that small-cap stocks much more attractive valuations become even more compelling when combined with the promising earnings outlook vis-à-vis large-caps,” Francis Gannon co-chief investment officer, and Chris Clark, CEO, president and co-chief investment officer at Royce, wrote in recent commentary.
While favorable valuations and rate cuts could provide tailwinds for small caps, one wildcard is the U.S. economy. The economy saw strong GDP growth in Q3, but inflation has increased and the job market has softened.
“All in all, small-caps offer a high-risk, high-reward opportunity with rate cuts as a tailwind, but investors must balance valuation gaps and macro risks,” Murillo added.
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