Finance
The riskiest stocks begin an epic rotation with rate cuts in sight
(Bloomberg) — The most speculative corner of the stock market is rising at a pace not seen since the pandemic, as traders rush to increase their rate cuts in a signal to the investment community.
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The small-cap Russell 2000 Index is up 12% over the past five sessions, something it hasn’t done since April 2020, while the S&P 500 Index is up just 1.6% in that time, and the tech-heavy Nasdaq 100 Index is down 0.3%. Additionally, the largest exchange-traded fund that tracks the Russell posted the second-largest inflows among stock ETFs last week.
It’s quite a turnaround for the small-cap benchmark, which was flat for the year early last week. The move appears to have been fueled by advances in the latest inflation data, particularly Thursday’s consumer price index, which sent two-year Treasury yields plunging and caused traders to raise their expectations for when the Federal Reserve would cut rates .
Smaller companies are generally sensitive to high financing costs because they have a heavier debt burden than big caps.
“Hedge funds and traders held record short positions in small-cap stocks as evidenced by last week’s CPI report and were caught off guard by lower-than-expected inflation,” said Cole Wilcox, CEO of Longboard Asset Management. “This led to the violent rally in small caps.”
Data on Russell 2000 futures shows traders increased their exposure to the most net short position since 2023. About 25% of the $68 billion iShares Russell 2000 ETF’s free float is held short, compared with 9.9% for the $564 billion SPDR S&P 500 ETF. Trust and 7.6% for the $302 billion Invesco QQQ Trust Series 1, according to data from S3 Partners.
Will the rally continue? Small caps have had several false starts over the past two years amid fluctuating expectations about when the Fed will cut rates. In addition, the group’s valuations have fallen to historic lows. Now those cheap multiples look like targets as the market takes a risky tone. Even with the latest rally, the Russell 2000 is up just 12% this year, dwarfed by the S&P 500’s 19% gain.
“The more attractive valuations could contribute to a very strong small-cap rally, along with a Fed rate cut,” said Eric Sterner, chief investment officer at Apollon Wealth Management.
The earnings outlook for small caps has also started to improve. Consensus sales and net income growth forecasts for the Russell 2000 show a strong recovery through late 2024, with the index closing in on the S&P 500, according to an analysis by RBC Capital Markets. The rate at which Russell 2000 earnings estimates are being revised higher is also starting to match that of the S&P, strategists led by Lori Calvasina found.
“This measure of earnings sentiment has been stronger for the S&P 500 for most of 2023, save for the last few months of the year when the Russell 2000 briefly moved back into line with the S&P 500,” Calvasina noted. RBC has “become more comfortable nibbling on small caps after last week’s inflation developments.”
The positioning of options confirms that investors are becoming increasingly optimistic about small caps. Implied volatility for one-month options on the iShares Russell 2000 ETF is the highest since April, suggesting traders are paying more to bet on bigger price moves, while the premium for put options that protect against the ETF’s decline is among the smallest shrunk since December.
Still, some Wall Street professionals warn that the small-cap rally may already have overheated. The Russell 2000 is the deepest into so-called overbought territory, a technically bearish sign, since 2017. That could mean the index is due for a reversal.
So the skeptics remain wary – at least until the move is confirmed by strong earnings figures.
“We’re not really chasing this,” said Garrett Melson, portfolio strategist at Natixis Investment Managers Solutions. “You probably want to fade until you actually see signs of growth starting to stabilize and pick up again.”
–With help from Natalia Kniazhevich, Alexandra Semenova and David Marino.
(This updates the index movements in the second and seventh paragraphs.)
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