Frenzy in US Small-Cap Stocks: Just a Short-Term Short Squeeze?

Recently, US small-cap stocks have finally turned the tide. With expectations of a Federal Reserve rate cut rising, funds have flocked to the Russell 2000 Index, which surged 12% in just five trading days. Despite a slight pullback in the last two days, the index's gain over the past week remains around 9%.

The iShares Russell 2000 ETF (IWM) emerged as a big winner, attracting $7.1 billion in inflows over the past week as of Wednesday, according to Bloomberg. In comparison, the Invesco QQQ Trust (QQQ), which tracks the Nasdaq 100 Index, attracted only about $2.7 billion during the same period. However, year-to-date in 2024, IWM has seen an outflow of $1.1 billion.

While investors revel in the small-cap stocks' frenzy, some analysts warn that this might just be a short-term short squeeze. Even if the rally continues, following the index might not be the right investment strategy.

Eric Johnston, Chief Equity and Macro Strategist at Cantor Fitzgerald, predicted in a recently released report that small-cap earnings this year are expected to be on par with 2021. He noted that the recent surge is partly due to a short squeeze and may not be sustainable; valuations are already at high levels, and short interest remains high.

Ed Yardeni, founder of Yardeni Research, emphasized the short squeeze nature of the recent surge in an interview with the media:

You see significant rises in biotech and banking, especially small regional banks, many of which might just be simple short-covering.

I don't know if their fundamentals have fundamentally changed, so I would be cautious about chasing mid-cap stocks and the Russell 2000.

Bank of America holds a similar view, noting in a report released on Thursday that short covering is a key factor driving the Russell 2000's rise, especially those stocks that were heavily shorted before.

Savita Subramanian, head of US equity and quantitative strategy at Bank of America, highlighted in a mid-year outlook conference call that one-third of Russell 2000 component companies are still unprofitable. She pointed out that among small-cap stocks, high-quality stocks are more attractive, such as those in the industrial and energy sectors. Companies that are more sensitive to GDP or consumption are also attractive, while those with higher refinancing risks or more sensitive to interest rates remain on watch until the Federal Reserve actually starts cutting rates.

Indeed, in trading on Wednesday and Thursday, small-cap stocks seemed to lose momentum. However, looking at many other small-cap stock funds beyond the IWM ETF, there is still a lot of optimism in the market.