U.S. small-cap stocks looked ready to take off this year after a mostly lackluster 2023, but volatility greeted investors over the past week, as uncertainty about when the Federal Reserve will cut interest rates crept into Wall Street after a mixed bag of inflation in January. Data.
The small-cap benchmark Russell 2000 index – which measures the performance of the 2,000 small and mid-sized companies included in the Russell 3000 RUA index – on Friday recorded its seventh straight session with a move of at least 1% in either direction, the longest such session lasting a series of 10 Sessions ended in March 2023, according to Dow Jones market data.
Over the week, the Russell 2000 advanced 1.1%, outperforming the tech-heavy Nasdaq Composite.,
Which fell by 1.3%, the largest margin since the week ending December 15 of last year. Additionally, the S&P 500 SPX fell 0.4% during the week, while the Dow Jones Industrial Average (DJIA) fell 0.1%, with all three major large-cap indexes snapping a five-week winning streak, according to Dow Jones Market Data.
“Small companies are almost directly the Fed's story or interest rates' story,” said Anna Rathbun, chief investment officer at investment advisory firm CBIZ. “You see more volatility in small caps because of their reliance on interest rates,” she told MarketWatch in a phone interview Thursday.
Rathbun said investors typically see small-cap stocks being punished when there is market sentiment that interest rates will stay high for longer, and they recover on signs that the central bank's monetary tightening cycle may be over.
On Tuesday, a sharp sell-off in US stock and government debt markets following a hotter-than-expected January inflation report sent the Russell 2000 index down nearly 4% — its worst day since June 2022 — as investors faced the grim prospect that interest rates would rise. Staying higher for several months longer than they had hoped.
However, investors breathed a sigh of relief over the following trading days, after dovish comments from Chicago Fed President Austin Goolsbee and a weak retail sales report revived hopes for the Fed's first rate cut in the coming months. The Russell 2000 index finished nearly 2.5% higher on Thursday, posting its best daily gain since December, according to FactSet data.
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Earlier this year, some investors bet on a big rebound for long-suffering small-cap stocks, with hopes that the sector's brief outperformance in December could have legs in the new year as interest rates fall and the U.S. economy heads toward a soft landing. .
However, the Russell 2000 is up just 0.3% so far this year, compared with a 4.9% advance for the S&P 500 and a 5.1% gain for the Nasdaq over the same period, according to FactSet data.
Small caps are close to catching up with their large cap counterparts after being left in the dust in 2023, with periods of negative correlation between interest rates and small caps tending to be short-lived, said David Lefkowitz, head of Americas equities at UBS Global Wealth Management. .
“We see no reason for it to be different this time, but even if this correlation remains intact, our fixed income team's forecast for the 10-year Treasury yield to fall to 3.5% by the end of the year should be supportive for investors,” Lefkowitz and his team said in a note to clients. From last week: “Small companies will outperform in the coming months.”
The yield on the 10-year Treasury note BX:TMUBMUSD10Y settled at 4.294% on Friday afternoon, after rising 10.8 basis points this week, according to Dow Jones market data.
Meanwhile, the chart below shows that it is common for small companies to outperform when interest rates rise and economic growth remains strong. But Lefkowitz and his team acknowledged that the recent rise in interest rates has not led to small-cap outperformance, because the recovery in earnings growth has not yet been “convincingly achieved.”
Source: Bloomberg, UBS
In fact, a resilient U.S. economy is usually needed to support the outperformance of small companies, but fluctuations in the Russell 2000 mean investors are not convinced the economy is on track for a soft landing at the moment, CBIZ's Rathbun said.
“What are the small business rates that we might not be thinking about? We keep talking about soft landings, not landing, but we're still flying in the air, and we're not close to the runway right now,” she said.
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For this reason, the “additional volatility” in small-cap stocks over the past week should be better described as an “opportunistic rotation” into a lagging sector as the Big Tech-led rally widens, rather than a “fundamental move” toward a lagging sector. Small stocks amid looser credit conditions or a strong U.S. economy, said Steve Sosnick, chief strategist at Interactive Brokers.
“[Small-cap stocks] They move because money is flowing into them while momentum carries stocks along the way — but the downside is that many stocks are unprofitable, meaning they either need a strong economy or relatively favorable prices in order to borrow money and stay afloat until they can. “It will be profitable,” Sosnick told MarketWatch in a phone interview Thursday.
Rotation may only be profitable for those who “manage to catch the waves,” Sosnick added, because unless there are signs of a strengthening economy or easing of credit conditions, the Russell 2000 is likely to face headwinds that its larger peers will not.
