By Louis Krauskopf
NEW YORK (Reuters) – U.S. small stocks are enjoying a much-needed rally, fuelled by hopes of lower interest rates and improving election prospects for Republican presidential candidate Donald Trump, a proponent of policies seen as favorable to the nation’s smaller businesses.
The small-company-focused Russell 2000 index surged more than 11.5% in five days, its biggest gain since April 2020.
Meanwhile, tech and growth stocks have been volatile, fueling a growing view that small caps are benefiting from this year’s blockbuster stocks shifting to the market’s underdogs. The tech-heavy Nasdaq 100 is down 3% since last week and posted its biggest one-day drop this year on Wednesday. The S&P 500, generally considered the benchmark for large U.S. stocks, is up 0.2%.
“I think that’s changed,” said Eric Kuby, chief investment officer at North Star Investment Management, which focuses on small-cap stocks. “I’m hopeful that this week’s surge is just the beginning of a very long, multi-year period in which small caps could make a big comeback.”
Shares of smaller companies have been underperforming for months while investors have poured money into big tech stocks, which have driven the indexes for much of 2024. Despite its recent surge, the Russell 2000 is up just 10.5% this year, while the S&P 500 is up 17% and the Nasdaq 100 is up nearly 18%.
That outlook changed last week when weaker-than-expected inflation readings stoked hopes that the Federal Reserve will cut interest rates in coming months, a potential boon for small businesses struggling with rising borrowing costs.
Rising interest rates are a “headwind for small-cap stocks,” said Jason Swiatek, head of small and mid-cap stocks at Jenison Associates. “However, as we move into a rate-cutting cycle, that pressure eases somewhat.”
The weekend assassination attempt likely fueled stock market gains, raising hopes of a victory for President Trump, whose proposals for higher tariffs and tax cuts could benefit small businesses.
Among the small-cap stocks that have surged since last week’s inflation data are biotech company Caribou Biosciences, which has risen 55% over the same period; homebuilder Hovnanian Enterprises, which is up more than 30%; and insurance company Hippo Holdings, which is up more than 29%.
A long-term retreat from tech stocks has sparked concerns over inflated valuations and drawn comparisons to the dot-com bubble two decades ago, but could lead to further gains for small-cap stocks.
The Russell 2000’s final market capitalization was $2.7 trillion, according to LSEG data, smaller than the individual market capitalizations of three stocks: Microsoft, Apple and Nvidia, each of which has a market capitalization of more than $2.9 trillion.
“As money leaves large-cap stocks and looks for new places to invest, it doesn’t take much to move small-cap stocks,” said Peter Taz, president of Chase Investment Counsel.
Historically, big gains in small-cap stocks have been a good harbinger of near-term performance: The Russell 2000 Index has risen more than 1% in the past week for five consecutive periods, something that has only happened four times before, according to Bespoke Investment Group. Following the previous winning streaks, the index rose an average of 5.9% over the following month, according to Bespoke.
While the S&P 500 has been hitting new record highs throughout the year, the Russell 2000 remains about 8% below its 2021 peak, suggesting small-cap stocks have room to rise.
Retail investors are also buying. Analysts at Vanda Research say the influx into small-cap stocks has sparked a “short squeeze,” when rising stock prices force bearish investors to unwind their bets against the stock, sending the stock price even higher.
“We believe there is room for retailers to continue chasing this deal over the next week or two,” they wrote.
Small-cap investors have been disappointed during good periods in stock prices before: Hopes for the prospect of rate cuts drove the Russell 2000 Index up more than 20% from late October to late December 2023, only for the index to fall earlier this year when rate cuts failed to materialize.
The ongoing earnings season could provide further justification for small caps, with Russell 2000 companies expected to post an 18% rise in second-quarter profits, according to LSEG. Large growth companies also have a chance to grab attention again, with big names Tesla and Alphabet reporting earnings next week.
Angelo Kourkafas, senior investment strategist at brokerage Edward Jones, said his outlook on small-cap stocks is “neutral” as he waits to see whether companies show stronger earnings growth.
He said he would need to see “profits much stronger than expected or further signs that economic activity is starting to recover” to be more optimistic about the group in the longer term.
(Reporting by Louis Krauskopf; Additional reporting by Suzanne Magee; Editing by Illa Iosebashvili and Leslie Adler)