The U.S. small cap rally has been fast and furious. But is it here to stay?

Executive summary:

• After months of struggle, U.S. small cap stocks have staged a remarkable turnaround in July, rising 9% so far this month. U.S. large cap stocks, meanwhile, are roughly flat on the month.
• The rally in small caps is being driven by multiple expansion rather than by actual earnings growth and profitability numbers.
• The small cap rally has primarily been a dae-risking event. It's unclear at this point whether it’s just a blip or the beginning of a new trend in market leadership.

Well, that was fast.

A month ago, we wrote about why allocating to small cap equities was still a good idaea. And in what feels like the blink of an eye, investors have piled into U.S. small cap stocks in droves the past two weeks–after months of mostly underweighting the asset class in favour of mega cap tech stocks. If it feels like it was only yesterday when small caps were making headlines for all the wrong reasons–their woeful underperformance in comparison to their large cap brethren being reason #1–it’s because it was.

Consider this fact: Only a month ago, the Russell 2000 Index of small cap stocks was mired in a years-long rut, having underperformed the large cap S&P 500 Index by 103% in the past decade. This 10-year stint of underperformance was so bad that it ranked as the fourth-worst stretch for small caps in comparison to large caps in a century. And as 2024 reached the halfway point, the Russell 2000 stood barely positive on the year–in stark comparison to the S&P 500 Index, which had posted a 15% gain thanks to the phenomenal performance of the Magnificent Seven.

And then came July.

CPI report sparks rally in small caps

Small cap stocks roared back to life in spectacular fashion on 11 July after June’s consumer price index (CPI) report showed further easing in inflation, pulling the market-implied odds of a September rate cut by the U.S. Federal Reserve (Fed) to nearly 100%. This report was the primary catalyst for a major rotation into small cap names, which typically have higher borrowing costs and are therefore more likely to benefit from lower interest rates. Case-in-point: The Russell 2000 shot up by 3.6% alone the day the June inflation numbers were released.

But that wasn’t all. Political developments in the U.S. over the next few days increased market expectations for a more deregulatory environment in 2025, pending the results of November’s U.S. presidential elections. And just like that, since 11 July, small cap stocks are up over 7%–compared to a 3% decline for large caps.

A rally driven by multiple expansion, not fundamentals

It’s worth emphasising that the rapid rise in small cap names isn’t being powered by actual earnings growth and profitability numbers. Rather, it’s being solely driven by multiples. This begs the question: Is the rally sustainable? Is this the beginning of a new trend in market leadership–with small caps leading the charge–or just a blip?

The short answer is that we don’t know enough yet to say either way. The speed and magnitude at which this rally unfolded has been dramatic, leaving us with a smaller-than-preferred sample size of data in which to assess the rotation. But what we’ve seen so far is that the small cap rally has primarily been a dae-risking event, with investors reducing some exposure to large cap positions.

Why? It’s likely because most managers had a good first half of the year, and wanted to at least partially lock in some gains. This led consensus long positions within hot sectors like tech and healthcare to be sold, in order to keep the books balanced. To wit, a popular hedge among hedge fund managers has been to short the Russell 2000 Index. This has helped spark an across-the-board rally in small caps due to lower liquidity in these names (compared to the mega cap names on the long side of this trade).

Lower quality companies have benefited the most

As would be expected, during this rally, the value factor has outperformed the growth factor. Perhaps more interesting is that lower quality U.S. companies have fared better across the board–regardless of style. These companies tend to be the consensus shorts against the higher quality companies that are consensus longs.

In addition, more defencive-oriented managers–those that don’t hold consensus long positions–have also tended to fare relatively well in this rally, since they didn’t have the same sort of exposure to the best performers in their long positions. In other words, these managers didn’t experience the selling pressures that the high-tech names did.

The sustainability of the rally is unknown. But an actively managed small cap allocation is worth considering.

Ultimately, we’re not quite sold on the sustainability of the small cap rally just yet. In recent days, the wind has come out of its sails a bit, with the Russell 2000 Index only up 0.5% so far this week–versus the 7% bounce observed between 11-18 July. Regardless, as of market close on 24 July, the Russell 2000 has climbed 9% in July¹, while the S&P 500 is trading roughly flat. It’s possible that disappointing earnings from some of the mega cap names may widen the difference between the two equity benchmarks even further in the final week of the month.

Either way, we still firmly believe that an allocation to small cap equities makes sense today. We see several long-term advantages to overweighting small cap stocks, and believe these advantages are best captured through active management and well-researched factor exposures.

An actively managed approach, after all, allows investors to select which specific companies they want to invest in–in contrast to a passive approach, where exposure to an entire small cap index means investors automatically own a large percentage of unprofitable companies. In addition, the combination of scarce sell-side analyst coverage and low stock-level correlation can provide compelling opportunities for skilled active managers.

The bottom line

The jury is still out on whether or not the current rally in small caps has staying power. At Russell Investments, we’ll continue to carefully monitor the situation and make any tactical adjustments as appropriate.

¹ Source: https://www.cnbc.com/2024/07/23/stock-market-today-live-updates.html