Small-cap U.S. stocks looked poised to take off this year after a mostly lackluster 2023, but volatility greeted investors in the past week as uncertainty over when the Federal Reserve will cut interest rates is returned to Wall Street after a mixed bag of inflation in January. data.
The small-cap benchmark Russell 2000 Index RUT – which measures the performance of 2,000 small- and mid-sized companies included in the Russell 3000 RUA Index – on Friday recorded its seventh consecutive session with a move of at least 1% in both directions, his longest session. running from a 10-session streak ending in March 2023, according to Dow Jones Market Data.
For the week, the Russell 2000 advanced 1.1%, outperforming the tech-heavy Nasdaq Composite COMP.,
which fell 1.3%, the widest margin since the week ending December 15 last year. Additionally, according to Dow Jones Market Data, the S&P 500 SPX index fell 0.4% on the week, while the Dow Jones Industrial Average DJIA fell 0.1%, with all three major large-cap indexes who recorded five-week winning streaks.
“Small caps are almost directly a ‘Fed story’ or a ‘rate story,’” said Anna Rathbun, chief investment officer at CBIZ Investment Advisory Services. “You see more volatility in small caps because of their dependence on rates,” he told MarketWatch in a phone interview Thursday.
Investors typically see small-cap stocks get penalized when there is a market sense that interest rates will stay higher for longer, and they rally on signs that the central bank’s tightening cycle may be over , Rathbun said.
A sharp sell-off in U.S. stock and government debt markets on Tuesday, following a hotter-than-expected January inflation report, dragged the Russell 2000 down nearly 4% — its worst day since June 2022 — as investors they faced the bitter possibility that interest rates would decline. stay higher for months longer than they hoped.
However, investors breathed a sigh of relief in subsequent trading days after dovish comments from Chicago Fed President Austan Goolsbee and a weak retail sales report revived hopes for an initial rate cut by the Fed. Fed in the coming months. The Russell 2000 closed about 2.5% higher on Thursday, marking its best daily percentage gain since December, according to FactSet data.
See: Battered small-cap stocks are starting to bounce back. Because they could fly in 2024.
Earlier this year, some investors were betting on a significant recovery in long-suffering small-cap stocks, hoping that the sector’s brief outperformance in December might find support in the new year as interest rates rise. fell and the US economy proceeded to a soft landing. .
Yet the Russell 2000 is up just 0.3% this year, compared to the S&P 500’s 4.9% and the Nasdaq’s 5.1% over the same period, according to FactSet data.
David Lefkowitz, head of equity for the Americas at UBS Global Wealth Management, said small-cap stocks are close to catching up with their large-cap peers after being left in the dust in 2023, due to periods of negative correlation between interest rates and small caps tend to be short-lived.
“We don’t see why it should be different this time, but even if this correlation remains intact, our fixed income team’s outlook for the 10-year Treasury yield to fall to 3.5% by the end of the year should be supportive for small-cap outperformance in the months ahead,” Lefkowitz and his team said in a client note last week.
According to Dow Jones market data, the 10-year Treasury bond yield BX:TMUBMUSD10Y stood at 4.294% Friday afternoon, after rising 10.8 basis points this week.
Meanwhile, the chart below shows that it is more common for small caps to outperform when rates rise and economic growth remains strong. But Lefkowitz and his team admitted that the recent rate hike has not led to small-cap outperformance because the recovery in earnings growth has not yet “happened convincingly.”
SOURCE: BLOOMBERG, UBS
Indeed, a resilient U.S. economy is generally needed to support small-cap outperformance, but the volatility of the Russell 2000 means investors aren’t convinced the economy is on track to achieve a soft landing at this time , CBIZ’s Rathbun said.
“What are small cap prices that we might not think about? We keep talking about soft landing, not landing, but we’re still flying in mid-air and we’re nowhere near the runway right now,” she said.
See: The stock market recovers from the inflation-induced collapse. Here is the message for investors.
That’s why the “extra volatility” in small-cap stocks over the past week should be better characterized as an “opportunistic rotation” into a lagging sector as the tech-megacap-led rally has broadened, rather than a “fundamental move ” toward small caps amid looser credit conditions or a strong U.S. economy, said Steve Sosnick, chief strategist at Interactive Brokers.
“[Small-cap stocks] they move because money flows into them as momentum drags stocks along the way, but the downside is that many stocks are unprofitable, meaning they need a strong economy or relatively favorable rates to borrow money and stay afloat until they can be profitable,” Sosnick told MarketWatch in a phone interview Thursday.
Sosnick added that the rotation could only be profitable for those who “catch waves successfully,” as unless there are signs of a strengthening economy or easing credit conditions, the Russell 2000 is likely to experience winds setbacks that its larger competitors will not suffer.