One of Wall Street’s most anticipated predictions for the start of 2024 has finally joined the stock market rally.
After significantly underperforming the broader market in the first half of the year, small-cap stocks have surged over the past week after June inflation came in better than expected, raising market optimism about a Federal Reserve interest rate cut.
Over the past month, the Russell 2000 (^RUT) index of small-cap stocks has risen about 10%, well ahead of the S&P 500’s 1.4% gain over the same period, and the pressing question now among Wall Street strategists is whether there’s room for this rally to continue.
“If rate cuts remain priced in and the Trump 2.0 trade continues ahead of the U.S. presidential election, we think there is room for a continued rotation into lower quality names,” Maxwell Grinacoff, U.S. equity derivatives strategist at UBS Investment Bank, wrote in a client note on Thursday.
Grinakoff added that the key to a continued rise is further containment of inflation and economic data showing the same or higher growth rates.
Savita Subramanian, head of U.S. equity and quantitative strategy at Bank of America, told Yahoo Finance on Wednesday that the small-cap trend is “likely to continue.” But to Subramanian, that doesn’t mean simply buying the Russell 2000 Index is the right trade.
Subramanian noted that roughly a third of the Russell 2000 index is unprofitable, and that the index as a whole faces much greater refinancing risk amid rising interest rates than indexes like the S&P 500.
“If short-term interest rates have indeed peaked and we are on track to see rate cuts, then as that certainty grows, small-cap companies are likely to start to outperform,” Subramanian said. “Certainly, small-cap valuations are at levels that justify a fairly fair comeback. I think it’s the higher quality groups within small caps that are looking more attractive. So within small caps, industrials and even energy companies, areas that may have more sensitivity to GDP and consumer spending, are going to look more attractive.”
He added that “areas with higher refinancing risk or higher credit sensitivity may still be subject to penalties until the Fed actually starts cutting rates.”
