Analysis: Rotation trade takes small caps from dead money to Wall Street darlings

Hovnanian Enterprises

18/07/2024 06:00

By Lewis Krauskopf
       NEW YORK, July 18 (Reuters) - U.S. small-cap stocks are
having a long-awaited moment, ignited by expectations of
interest rate cuts and improving prospects for the election of
Republican presidential candidate Donald Trump, a proponent of
policies seen as benefiting smaller domestic companies. 
    The small-company-focused Russell 2000  .RUT  surged more
than 11.5% over five days, the index's biggest gain in such a
stretch since April 2020. 
    At the same time, tech and growth stocks have wobbled,
reinforcing the view that small caps have benefited from a
rotation out of this year’s biggest winners into unloved areas
of the market. The tech-heavy Nasdaq 100  .NDX  is down 3% since
last week, including its biggest one-day drop of the year on
Wednesday. The S&P 500  .SPX , generally considered the
benchmark for large-cap U.S. stocks, is up 0.2%. 
    "I think the narrative has changed," said Eric Kuby, chief
investment officer at North Star Investment Management Corp,
which specializes in small-cap stocks. "I'm hoping ... this jump
over the last week is really just the beginning of what could be
a very long, multi-year period of time where small caps could
make up a lot of ground."
    For months, shares of smaller companies have languished
while investors poured money into the massive tech stocks that
have led indexes for most of 2024. The Russell 2000 is up only
10.5% this year despite the recent surge, while the S&P 500 has
gained 17% and the Nasdaq 100 is up nearly 18%.
    The outlook shifted last week, when a softer-than-expected
inflation reading boosted expectations the Federal Reserve will
cut rates in coming months, a potential boon to smaller
companies suffering from elevated borrowing costs. 
    Higher rates have been a "headwind to small caps," said
Jason Swiatek, head of small- and mid-cap equity at Jennison
Associates. "On the flip side, as you switch to a rate-cutting
cycle, that alleviates a bit of that pressure."
    The rally accelerated after a failed assassination attempt
over the weekend appeared to increase expectations of a victory
by Trump, whose proposals to raise tariffs and lower taxes could
benefit smaller companies. 
    Among the small-cap stocks that have surged since the
inflation data last week are biotech firm Caribou Biosciences
 CRBU.O , up 55% in that time, homebuilder Hovnanian Enterprises
 HOV.N , up over 30%, and insurer Hippo Holdings  HIPO.N , up
over 29%.
    An extended rotation out of tech - whose run has sparked
concerns over stretched valuations and drawn comparisons to the
dotcom bubble two decades ago - could fuel further small-cap
strength. 
    The Russell 2000 last had a total market value of $2.7
trillion, according to LSEG data. That's smaller than the
individual market values of three stocks, Microsoft  MSFT.O ,
Apple  AAPL.O  and Nvidia  NVDA.O , with market caps each over
$2.9 trillion.
    As money flows "come out of the megacap stocks and they look
for a new home, it doesn't take much to get the smaller stocks
going," said Peter Tuz, president of Chase Investment Counsel.
    History shows that a sharp rally by small caps bodes well
for their near-term performance. The Russell 2000 gained at
least 1% in five straight sessions over the past week, which has
only happened four times before, according to Bespoke Investment
Group. Following those prior streaks, the index posted an
average gain of 5.9% over the next month, according to Bespoke.
    While the S&P 500 has notched record highs all year, the
Russell 2000 remains some 8% below its 2021 peak, suggesting
small caps may have room to climb.
    Retail investors are buying as well. Analysts at Vanda
Research said inflows into small caps sparked a “short squeeze,”
when a rising price forces bearish investors to unwind bets
against a stock, driving it even higher. 
    “We think there’s scope for retail to continue chasing this
trade over the next 1-2 weeks,” they wrote.
    Small-cap investors have been disappointed by periods of 
strength before. Excitement over the prospect of rate cuts sent
the Russell 2000 up over 20% between late October and late
December of 2023, only for the index to retreat earlier this
year when rate cuts did not materialize.
    The earnings season now getting underway could provide more
justification for small caps, with Russell 2000 companies
expected to post an 18% rise in second-quarter earnings,
according to LSEG. Megacap growth companies will also have a
chance to reclaim the narrative, with heavyweights Tesla
 TSLA.O  and Alphabet  GOOGL.O  reporting next week.
    Brokerage firm Edward Jones has a "neutral" outlook on
small-caps as it waits to see if companies can show stronger
profit growth, said Angelo Kourkafas, senior investment
strategist at the firm.
    To be more optimistic on the group longer-term, he said, "We
would need to see more signs that either earnings are coming in
much better than expected or that economic activity is starting
to pick up.” 

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Playing catch-up in US stocks    https://reut.rs/4eZSDDo
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 (Reporting by Lewis Krauskopf; additional reporting by Suzanne
McGee; Editing by Ira Iosebashvili and Leslie Adler)
 ((lewis.krauskopf@thomsonreuters.com; Twitter: @LKrauskopf;))