Small Cap Stocks Soar Along with Investors’ Rate-Cut Expectations

Rising expectations that the Federal Reserve will cut interest rates in September have powered small-cap stocks higher over the past week.

The reason: Lower rates are seen as beneficial to smaller companies, which generally have higher levels of debt than bigger ones and can be more susceptible to economic stress. Traders now appear certain the Fed will start cutting rates at its September meeting, an environment that has encouraged investors to pour money—at historic rates—into the stocks of companies with market values generally less than $2 billion.

The Russell 2000 Index (RUT), which slipped Wednesday after five days of gains, is up about 9% over the past five sessions, before which they were near-flat for the year. By comparison, the S&P 500 Index, has slid during those same five sessions, though it’s up some 17% for the year.

The question now is how long the small-cap rally can continue in a stock market dominated for more than a year by several large, high-profile technology stocks.

Historic Gains for Small Caps

The small-cap surge has yielded historic results. Since 1990, the Russell 2000 Index gained more than 10% in a five-day stretch just 32 times. On average, the index posts a five-day gain of 0.2%. The index gained more than 1% in each of its five most recent gains, only the fifth time that has happened.

History shows small caps can outperform large caps for extended periods. From 1979 through 1983, for example—a period that included double-digit interest rates, double-digit inflation and two recessions—the Russell 2000’s returns surpassed those of the S&P 500 by 80%. From 1990 through 1994, the small-cap index outperformed by 50%, and in a 15-year stretch from 1999 through 2014, the Russell 2000 more than doubled the S&P 500’s return.

What’s Ahead for the ‘Flavor of the Moment’

The week-long rally may or may not presage economic turbulence, even as U.S. economic growth has shown signs of cooling. Still, some analysts suspect that investors have splurged too much on small-caps even if there isn’t economic turbulence ahead.

According to Bespoke Investments, the Russell 2000 Index as of Tuesday’s close represented the most “overbought” condition of any leading U.S. index, perhaps presaging selling that erases gains. However, analysts with DataTrek in a Wednesday note small caps have benefited from the most notable shift in investors’ sentiment in three decades.

“The fact that the Russell 2000’s recent rally is both statistically and historically unusual tells us investor sentiment has shifted dramatically,” DataTrek said in its note, “and the move very likely has further to run.”

Small caps could beat the S&P 500 in the third quarter, DataTrek analysts wrote, calling them “the flavor of the moment.”