In the past week, bolstered by the market's anticipation of a Fed rate cut cooling down and Trump's trade moves, the important U.S. small-cap stock index, the Russell 2000 Index (.RUT.US), has shown strong performance, outperforming the large-cap index, the S&P 500 Index (.SPX.US). Investors are beginning to put real money into betting on the imminent arrival of a U.S. stock market rotation, with demand for call options related to the Russell 2000 Index surging.
Wall Street giants are also starting to voice bullish sentiments on small-cap stocks. Wells Fargo and Morgan Stanley have pointed out that financial and energy stocks, as well as small growth stocks, are expected to perform well.
Russell 2000 Index Begins to Outperform Large-Cap Stocks
As market expectations for a Fed rate cut rise, lower interest rates could help expand the stock market rally. The first half of the year saw the rally in U.S. stocks mainly led by a few large-cap companies like Nvidia (NVDA.US). However, last week saw a significant shift, with small and mid-cap stocks outperforming the large-cap S&P 500 Index again on Thursday and Friday. The benchmark for small-cap stocks, the Russell 2000 Index, achieved its best weekly performance since 2024. Notably, on Thursday and Friday, small and mid-cap stocks comprehensively outperformed the Magnificent 7, the seven tech giants that have led the entire U.S. stock market since 2023.
This week, small-cap stocks continued to outperform large-cap stocks. Since the rebound began last week, the index has broken through a trading range of over two years. On Tuesday, the Russell 2000 Index outperformed the S&P 500 Index for the fourth consecutive trading day. On Tuesday, supported by increased bets on rate cuts starting this year and the continued downward trend in U.S. Treasury yields, the Russell 2000 small-cap index recorded a five-day winning streak, closing up 3.5%. The cumulative gain over the past five trading days reached 12%, with a year-to-date gain of 11%. The Russell 2000 Value Index has risen by 8.6% this year, while the Russell 2000 Growth Index has risen by 14.9%. The S&P 500 Index has surged nearly 19% in 2024.
Matt Miskin, Co-Chief Investment Strategist at investment management company John Hancock, stated that lower interest rates could benefit market sectors impacted by rising rates due to the surge in large tech stocks. This includes small-cap companies, which are often more sensitive to interest rates due to their higher reliance on financing. He said, In many cases, small-cap companies need funding to survive, and rising capital costs present real challenges to their operations. Lower funding costs will definitely help these companies.
Dan Wantrobski from Janney Montgomery Scott indicated that one of the biggest questions about the market's movements in the previous trading day is whether this marks a trend reversal over the past year and a half or just a one-off. He stated, Technically speaking, we cannot confirm that yesterday's action is the start of a sustainable long-term trend. However, from a trading trend perspective, we do believe we might continue to see further thematic rotation into small and mid-caps in the short term, as technical charts still show potential for mean reversion.
Investors Pour Real Money into Small-Cap Stocks, Call Option Demand for Russell 2000 Index Surges
According to Mandy Xu, Head of Derivatives Market Intelligence at Cboe Global Markets (CBOE.US), demand for call options related to the Russell 2000 Index and ETFs tracking the index has surged over the past few trading days, pushing these contracts to trade at premiums over put options.
This suggests that the small-cap stock rebound may have further upside in the short term. Xu noted that a similar pattern emerged at the end of 2023, when investors drove up stocks expected to benefit from significant Fed rate cuts. FactSet data shows that the Russell 2000 Index rose by more than 20% from early November to early December last year, outperforming the S&P 500 Index and the Nasdaq Composite Index (.IXIC.US).
Xu said, We saw extreme bullish sentiment towards small-cap stocks in the fourth quarter of last year, but as rate cut expectations waned, this trade gradually faded. Will it be different this time?
Call options give traders the right to buy the underlying stock or ETF at a specified price before the option expires, while put options give traders the right to sell. Options contracts related to indices are typically settled in cash.
Dow Jones market data indicates that last Thursday, the trading volume of call options related to the Russell 2000 Index and the iShares Russell 2000 ETF reached the highest levels in recent years. Nearly 2.1 million call options related to the ETF changed hands on that day, marking the highest daily trading volume since December 2009 and the sixth highest since 2005. The trading volume of call options directly related to the index reached the highest level since 2021.
Data shows that last Thursday was the best performing day for the Russell 2000 Index since November last year. Since then, demand for call options has remained high. Data shows that last Friday and Monday, the trading volume of call options related to the iShares ETF was still more than triple the daily average trading volume of the past two years.
U.S. Small-Cap Stocks Welcoming Rate Cut Speculation, Morgan Stanley Recommends Investing in Small Growth Stocks
Morgan Stanley's U.S. equity strategists suggest that as the Fed may cut rates, investors should consider investing in small growth stocks. Morgan Stanley Global Research Director Katy Huberty stated in a report on Tuesday that strategists' subtle relative judgment on U.S. small-cap stocks indicates a preference for growth stocks over value stocks.
During a Microsoft (MSFT.US) conference call, Huberty stated, With yields falling, long-duration small-cap stocks that are growth-oriented and more sensitive to changes in capital costs will benefit relatively, while small-cap stocks that are more economically sensitive (i.e., value) will not benefit.