The Post-Election Small-Cap Surge: Why It's Unlikely to Sustain

The postelection rally in the market's smallest stocks has been impressive, with investors bullish on President-elect Trump's economic policies. However, history suggests that this rally may not last. This article explores why the current small-cap surge is unlikely to sustain, drawing on expert opinions and market data.

The postelection rally in small-cap stocks has been fueled by optimism surrounding President-elect Trump's policies, particularly tax cuts and deregulation. According to Morningstar Indexes Strategist Dan Lefkovitz, the Morningstar US Small Value Index surged after the 2016 and 2020 elections, driven by market expectations for these policies. However, both rallies proved temporary as market fundamentals reasserted themselves.

The current rally in small-cap stocks is particularly strong, with the Russell 2000 index up more than 4% on Election Day and reaching year-to-date highs. This outperformance is driven by the market's bet that domestically focused, economically sensitive sectors like financial services, basic materials, and consumer cyclicals will thrive under Trump's policies. However, this optimism may be misplaced.

First, history shows that postelection rallies in small-cap stocks tend to be short-lived. In 2016 and 2020, the small-cap rallies fizzled when market fundamentals reasserted themselves. This time, the rally may fade as economic realities set in. Additionally, sector-specific factors may hinder the sustainability of the rally. For instance, financial services stocks could face headwinds from potential regulatory changes, while basic materials and consumer cyclicals may be hurt by geopolitical risks and slower global economic growth.

Second, the market's sensitivity to broader economic conditions suggests that any slowdown in growth or higher interest rates could negatively impact small-cap stocks. The Federal Reserve is expected to cut rates again, which could benefit debt-heavy small caps in the short term. However, any subsequent rate hikes could reverse this effect. Moreover, a corporate tax cut, if enacted, could provide a longer-term boost for small caps. However, trade dynamics, such as tariffs, may negatively impact small caps due to their higher domestic revenue exposure.

In conclusion, the postelection rally in small-cap stocks is unlikely to sustain, given the historical patterns and broader economic indicators. While the initial optimism may drive the small-cap rally, underlying sector-specific challenges and broader economic factors could eventually terse the momentum. Investors should consider these factors when evaluating the potential longevity of the current small-cap rally.