One of Wall Street’s favorite signals to kick off 2024 has finally joined the stock market rally.
After significantly underperforming the broader market in the first six months of the year, small caps have rallied in value this past week, driven by better-than-expected inflation in June, which has made markets increasingly optimistic about the Federal Reserve cutting rates.
The small-cap Russell 2000 (^RUT) index has risen about 10% over the past month, far outpacing the S&P 500’s 1.4% over the same period. And the burning question among Wall Street strategists now is whether the rally has more room to run.
“We believe there is room for rotation to low quality if rate cuts remain in the price and the Trump 2.0 trade continues ahead of the US election,” Maxwell Grinacoff, U.S. equity derivatives strategist at UBS Investment Bank, wrote in a note to clients on Thursday.
Grinacoff added that the key to continuing the rally lies in further cooling of inflation and economic data showing a similar or higher pace of growth.
Savita Subramanian, head of U.S. equities and quantitative strategy at Bank of America, told Yahoo Finance on Wednesday that the trend in small caps is “likely to continue.” But for Subramanian, that doesn’t mean simply buying the Russell 2000 index is the right trade.
Subramanian pointed out that about a third of the Russell 2000 is unprofitable and that overall the index faces much more refinancing risk due to higher interest rates than an index like the S&P 500.
“If we are in fact at a point where short-term interest rates are peaking, and we are likely to see cuts, as that certainty improves, small-cap companies are likely to outperform,” Subramanian said, “Indeed, their valuations are at levels that would justify a fairly fair comeback. I think the areas within the small-cap spectrum that look more attractive are the higher-quality cohorts. So within small caps, industrials, even energy companies, areas that are potentially more GDP-sensitive, more consumption-sensitive, would look more attractive.
She added: “Areas with greater refinancing risk or greater credit sensitivity may remain in the penalty box until the Fed actually starts cutting rates.”