America's 3,000 biggest public firms have a stark imbalance. The top 1,000 make up 95% of their total value, while the rest – represented by the Russell 2000 index – are collectively worth less than Apple.
But right now, the underdogs of America's stock market are finally basking in the spotlight. For most of this year, Russell 2000 shareholders have watched from the sidelines as the big-stock S&P 500 gained nearly 20%. That’s now shifted and the Russell 2000 has charged ahead, soaring 8% in a month and hitting its highest level since early 2022, all while the S&P 500 barely budged. Analysts are now buzzing about whether the rally – and the Russell 2000’s biggest outperformance in history – is a fluke, the start of a "small-cap summer," or even a major about-face from big stocks to little ones.
From where I stand, I see three very good reasons why investors seem to be falling in love with small American firms.
Better odds for a potential rate cut. US inflation data for June brought some exciting news – a month-over-month decrease in prices for the first time since 2020, and a smaller-than-expected increase in year-over-year prices. Meanwhile, Bank of America’s fund manager survey showed that higher inflation is no longer investors' biggest fear. Now, with inflation seemingly under control, the odds of an interest rate cut, which typically would give small stocks a bigger boost than the big ones, seem a lot more likely. Not only are the Russell 2000’s fortunes closely tied to the health of America’s economy, but those lower interest rates would also give their balance sheets some much-needed relief. This combo of decent growth, easing inflation, and potential rate cuts is an all-around dream come true.
The change in fund flows. Technical factors are a big deal for less-sizable stocks, because of their smaller market value and lower liquidity. At the beginning of July, hedge funds were holding a near-record short position in small-cap stocks, essentially betting that they would fall. And, when so many market players are on one end of the boat, it doesn’t take much to flip the thing over. So, it wasn’t just funds scrambling to unwind their negative positions. For the week ending July 12th, stock ETFs saw their second-highest inflows this year. While big-cap ETFs got most of the money, small-caps were the real stars. The iShares Russell 2000 ETF saw $3.7 billion flow in, which is over 6% of its market cap. Compare that to the 2.4% market cap flows seen by the SPDR S&P 500.
And political plays. With the US election coming up, investors have been busy reassessing their portfolios. And in one way, betting on small firms can seem like a smart move if the next American president is someone who talks pro-business but isn’t fond of the tech giants. The Russell 2000, with its homegrown focus, could also be a cozy hideaway from any US political mishaps overseas, while also reaping the benefits of reshoring efforts and lower corporate taxes at home.
Just remember that things can change quickly for the small-cap crowd. Last December, small-caps rallied on the hopes of imminent interest rate cuts, only for the excitement to fizzle out when it became clear those reductions were still a distant dream. So this time around, a hint of reluctance on the rate-cutting front could put a damper on the party pretty fast.
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