Small Cap Stocks Are Having A Moment: Russell 2000 Notches Best 5-Day Rally In Over 4 Years

Small-cap stocks are on a tear, eyeing their fifth consecutive day of gains on Tuesday. The iShares Russell 2000 ETF IWM surged 1.9%, propelling the index to a cumulative gain of over 9% across the last five sessions. This remarkable streak represents the Russell 2000’s best five-day performance since June 2020.

The turbocharged rise of small caps is attributed to the certainty at this point that the Federal Reserve will lower interest rates at its September meeting. In fact, the Russell 2000 rally kicked off last week, driven by June inflation data coming in below expectations, sparking traders’ speculation about rate cuts.

According to the CME Group’s FedWatch Tool, fed futures now indicate a full 100% probability of an interest rate cut in nearly two months, marking the first reduction in borrowing costs since 2020. On Monday, Fed Chair Jerome Powell struck a dovish tone, acknowledging that recent inflation reports bolster confidence in returning to the 2% target, effectively hinting at forthcoming rate cuts.

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Chart: Russell 2000 Notches Best 5-Day Upswing In Four Years

Image: Benzinga Pro

Investors Rotate From Tech To Small Caps

Small caps’ heightened sensitivity to interest rate expectations stems from their greater reliance on bank financing, unlike large-cap companies that frequently raise funds through stock and bond issuance in capital markets.

This is leading investors to shift their focus from early beneficiaries of rate cuts – mainly large-cap tech – to those expected to gain at a later stage (small caps and cyclical stocks).

Over the past five sessions, the Russell 2000 Index has outperformed the tech-heavy Invesco QQQ Trust QQQ – which tracks the Nasdaq 100 – by 10.4 percentage points, marking the widest five-day relative gain of small caps over tech since November 2016.

“There's certainly a bullish interpretation to the rotation, as any profit-taking in ‘overvalued' tech gets funneled into more neglected areas of the U.S. stock market. This buying, in turn, should lift all boats, just as it has helped the old-school Dow to smash above 40,000 to trade at new record highs,” said David Morrison, senior market analyst at Trade Nation.

Preference For Small-Cap Value

“We still have questions on whether this rally is sustainable,” said Ayesha Tariq, macroeconomist and founder of Macrovisor.

Tariq highlighted that the performance of regional banks, which constitute a significant portion of the Russell 2000, remains uncertain as they have yet to report their earnings. While investment banks have shown strong results driven by trading activities, their net interest margins (NIMs) and wealth management divisions are still facing challenges. For instance, Bank of America has reported a 3% decrease in net interest income (NII), and Wells Fargo has seen a 9% decline.

Additionally, the persistence of relatively high yields indicates that regional banks may continue to face unrealized losses on their balance sheets, according to the expert.

Despite the recent rally, Tariq indicates that the Russell 2000 is still grappling with an earnings recession. However, she suggested that from an investment perspective, small-cap value stocks might be more appealing.

She referred to a chart shared by Bank of America that shows the valuation gap between large-cap growth – as tracked by the iShares S&P 500 Growth ETF IVW and small-cap value stocks – as monitored through the iShares Russell 2000 Value ETF IWN – was at its widest since 2000, prior to the recent small-cap rally, indicating potential for further a “catch-up” and rotation trade.

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• Rate-Sensitive Cyclical Stocks Poised For Rally As Fed Prepares To Cut Rates: ‘We’re On The Path To Goldilocks,’ Says Bank Of America

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