Small-cap stocks, generally defined as companies with a market capitalization between $300 million and $2 billion, have had an impressive month, surging over 10% since the start of July. This strong performance follows encouraging economic news and a shift in investor sentiment. In stark contrast, large-cap, tech-heavy indices like the S&P 500 and NASDAQ have posted negative returns of -0.61% and -5.06%, respectively, during the same period.

Positive Economic Signals

The week of July 9th kicked off with cooling inflation data and optimistic remarks from Federal Reserve Chair Jerome Powell, which fueled speculation about upcoming rate cuts by the Federal Open Market Committee's (FOMC). The CME FedWatch tool now indicates futures markets are predicting a 100% chance that the target fed funds rate will decrease by at least 0.25% following the September 18th meeting.¹ This potential rate cut is significant for small cap stocks, which tend to rely more heavily on leverage and floating rate debt. As interest rates fall, these companies could see a greater benefit compared to the mega-cap technology stocks that have dominated market performance in recent years.

Historical Context

Prior to this rally, small-caps had experienced their worst performance relative to larger-cap stocks in over 20 years. High inflation and rising borrowing costs have significantly impacted these smaller companies, making it challenging for them to compete with larger, more established firms. However, the recent shift in economic conditions has quickly breathed new life into the small cap sector.

Valuation Gap

As of July 26, 2024, small-cap stocks were trading at a substantial 57% discount compared to their large-cap counterparts on a weighted average price-to-earnings (P/E) basis.² This valuation gap indicates that, in addition to the inherent market discount due to higher financial risk and price volatility, recent economic and inflationary pressures have led to the market discounting the growth potential and earnings power of small-cap companies.

Comparative Performance of S&P 500, Nasdaq, and Russell 2000 from July 1, 2024 to July 31, 2024

Market Rotation

The recent surge in the Russell 2000, an index that tracks the performance of 2,000 small-cap stocks, highlights a rotation of some investors out of the previously favored tech giants and into companies with more attractive valuations. As economic conditions become more favorable, small caps could be poised for an exciting rally; however, investors should carefully consider their risk tolerance and investment goals when evaluating opportunities in the small-cap space.

References

1 CME FedWatch Tool: https://www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html 

2 Data retrieved from YCharts on July 30, 2024. As of July 26, 2024, the IWM weighted average P/E ratio was reported as 14.91 as compared to the SPY weighted average P/E of 26.1.

3 Index performance data retrieved July 30, 2024.