(Bloomberg) — U.S. stocks, the most speculative corner of the stock market, are surging at a pace not seen since the pandemic as traders race to raise interest-rate cut expectations as a risk-on signal for investors.
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The Russell 2000 index of small-cap stocks is up 10% over the past five sessions, the most since April 2020. Meanwhile, the S&P 500 is up just 1.4% over the same period, and the tech-heavy Nasdaq 100 is down 0.4%.What’s more, the largest exchange-traded fund that tracks the Russell index saw the second-largest inflows of any equity ETF last week.
That’s quite a turnaround for the small-cap index, which had been flat for the year to date early last week. The move was likely triggered by the latest inflation data, specifically Thursday’s developments in the Consumer Price Index, which caused two-year Treasury yields to plummet and prompted traders to bring forward their expectations about when the Federal Reserve will cut interest rates.
Smaller companies are generally more heavily indebted than larger companies and are therefore more sensitive to rising borrowing costs.
“Hedge funds and traders had built up record short positions in small-cap stocks before last week’s CPI release and were caught off guard by the weaker-than-expected inflation,” said Cole Wilcox, CEO of Longboard Asset Management. “That sparked a surge in small-cap stocks.”
Traders have boosted exposure to the largest net short position since 2023, according to data on Russell 2000 futures. About 25% of the $68 billion iShares Russell 2000 ETF’s float is short, compared with 9.9% in the $564 billion SPDR S&P 500 ETF Trust and 7.6% in the $302 billion Invesco QQQ Trust Series 1, according to data from S3 Partners.
Will the rally continue? Over the past two years, small caps have lagged several times as expectations of Fed rate cuts fluctuated. In the process, valuations of this group have fallen to all-time lows. Now, with a risk-on mood in the market, these undervalued indexes look like targets. Despite its latest gains, the Russell 2000 is up just 10% this year, dwarfed by the S&P 500’s 19% gain.
“More attractive valuations, along with Fed rate cuts, could spark a very strong small-cap rally,” said Eric Sterner, chief investment officer at Apollon Wealth Management.
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Small-cap earnings outlooks are also starting to improve: According to analysis by RBC Capital Markets, consensus estimates for Russell 2000 revenue and net income growth are set to rebound strongly in the second half of 2024, moving closer to the S&P 500. Strategists led by Lori Calvasina found that the rate of upward revisions to Russell 2000 earnings estimates is also starting to return to parity with the S&P.
“This indicator of earnings sentiment has been stronger in the S&P 500 for much of 2023, except for a few months at the end of the year when the Russell 2000 briefly returned to parity with the S&P 500,” Calvasina noted.RBC is “feeling more comfortable investing in small-cap stocks following last week’s inflation moves.”
Options positioning confirms that investors are becoming increasingly bullish on small-cap stocks. The implied volatility of one-month options on the iShares Russell 2000 ETF is at its highest since April, suggesting traders are paying more to bet on bigger price movements, while the premium for put options to protect the ETF from downside has shrunk to the lowest since December.
Still, some Wall Street pros are warning that the small-cap rally may already be starting to overheat: The Russell 2000 is deepest into so-called overbought territory, a bearish technical indicator, since December, which could mean the index is due for a reversal.
So skeptics remain cautious, at least until the move is confirmed by positive financial results.
“We’re not really chasing this,” said Garrett Melson, portfolio strategist at Natixis Investment Managers Solutions Inc. “Until we really start to see signs that growth is stabilizing and starting to pick up, it’s probably best to stay calm.”
–With assistance from Natalia Kniazhevich, Alexandra Semenova, and David Marino.
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