Russell 2000 Notches Third Week Of Gains, Strongest Streak Since August 2022: Small Caps Serve 'As Economic Barometer,' Analyst Says

Small-cap stocks celebrated their third consecutive week of gains, driven by growing investor optimism towards interest rate-sensitive industries and companies, bolstered by firm expectations of a Federal Reserve rate cut in September.

Markets are currently pricing in a 100% likelihood of a Fed rate cut in less than two months, and are factoring in nearly three rate cuts by year-end, according to CME Group’s FedWatch tool.

This optimism is further strengthened by the absence of fears regarding an imminent economic slowdown, creating a landscape particularly favorable for small-cap stocks.

Economic data released this week revealed that the U.S. economy expanded its output at a 2.8% annualized pace in the second quarter, beating expectations of a 2% surge and doubling the performance compared to the first quarter. Moreover, jobless claims showed an ease last week, quelling fears of a rapid cooling in labor market conditions.

As real growth has expanded, price pressures have eased significantly. Last month, a widely followed Federal Reserve inflation gauge dropped to 2.5%, its lowest level since February 2021.

In the past three weeks, small-cap stocks have surged by over 11%, marking their strongest three-week rally since August 2022.

In July, the iShares Russell 2000 ETF IWM attracted over $6 billion in inflows, registering the strongest influx year to date.

Chart: Russell 2000 Index Notches Strongest 3-Week Rally In Nearly Two Years

Small Caps Reflect Confidence In Solid Economic Backdrop

Small caps serve as ‘an economic barometer,’ according to Quincy Krosby, chief global strategist for LPL Financial.

The expert explains that the prospect of interest rate cuts has fueled a surge in smaller stocks, which are more sensitive to interest rate changes than the S&P 500, particularly compared to the dominant mega-tech names that have led the market for most of this year.

Attractive valuations have further supported this trend. Krosby highlights that the stability and gains in the larger and broader financial sector have positively impacted the Russell 2000, which is heavily weighted with small to mid-sized banks.

Recent data indicates that while the economy is cooling, “it isn't on the precipice of collapsing,” Krosby said.

Krosby suggests that the continued inflows into small-cap stocks, despite political and economic uncertainties, signal investor confidence in a solid economic backdrop combined with anticipated lower interest rates.

However, she cautions that small-cap stocks, with their higher risk profile compared to the S&P 500, are prone to quick sell-offs if investors perceive a significant shift in economic direction.

Next week's focus will be on a heavy package of economic data, including the payroll report, factory orders, the FOMC meeting, and key technology earnings reports, which should continue to support the small-cap renaissance.

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