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The Small-Cap Rally: A Risk-On Signal for the Investment Community

Market Surge

The most speculative corner of the stock market is experiencing a remarkable surge, with the small-capitalization Russell 2000 Index soaring 12% in the last five sessions, a pace not seen since the pandemic. This significant gain is a stark contrast to the 1.6% rise in the S&P 500 Index and the 0.3% decline in the technology-heavy Nasdaq 100 Index over the same period.

Rate Cut Bets

The move appears to have been sparked by progress in the latest inflation data, particularly Thursday’s consumer price index, which sent the two-year Treasury yield plummeting and caused traders to pull forward their expectations for when the Federal Reserve will cut interest rates. Smaller companies, which typically carry heavier debt loads than big caps, are particularly sensitive to high borrowing costs.

Hedge Funds and Traders

Hedge funds and traders held record short positions in small-cap stocks going into last week’s CPI report and were caught off guard by the lower-than-expected inflation. This sparked the violent rally in small caps, with traders rushing to cover their short positions and buy into the momentum.

Valuations

The rally has pushed small-cap valuations to historic lows, making them an attractive target for investors. Even with the latest rally, the Russell 2000 is up just 12% for the year, dwarfed by the S&P 500’s 19% rise. However, the more attractive valuations could help trigger a very strong small-cap rally along with the Fed cutting rates.

Earnings Outlook

The earnings outlook for small caps has started to improve, with consensus revenue and net income growth forecasts showing a strong recovery in late 2024, approaching the S&P 500. The rate of Russell 2000 earnings estimates getting revised higher has also started to move back to parity with the S&P.

Options Positioning

Options positioning confirms that investors are becoming increasingly bullish on small caps, with the implied volatility for one-month options on the iShares Russell 2000 ETF at its highest since April, signaling traders are paying more to bet on bigger price moves.

Caution

However, some Wall Street pros warn that the small-cap rally may have already begun to overheat, with the Russell 2000 the deepest into so-called overbought territory since 2017. This could mean the index is due for a reversal.

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