Will the Fed's Rate Cut Fuel Further Gains in Small-Cap Stocks?
2min read Since the Federal Reserve hinted that the first interest rate cut of the year could be imminent, U.S. small-cap stocks have experienced an epic rebound over the past month - yet investors remain concerned about whether one of the most battered corners of the market can continue to rise amid uncertainty about the economic and monetary policy outlook.
According to FactSet data, the Russell 2000 Index has risen by 3% over the past month, while the large-cap benchmark S&P 500 Index has only risen 1.4% during the same period.
Small-cap stocks have been volatile since the Fed's signal. The Russell 2000 Index soared by about 13% in July, achieving its best monthly performance in nearly two years, but almost gave up half of its gains in August. Now, market analysts believe this bullish momentum could continue.
Participants in the stock market are generally optimistic that small-cap stocks will continue to outperform the broader market in the coming months—mainly due to expectations that the Federal Reserve will begin cutting interest rates on Wednesday, as well as the possibility of a so-called soft landing for the U.S. economy.
Small-cap stocks are typically more sensitive to changes in borrowing costs and economic conditions, as smaller companies often have higher debt levels than larger companies and rely more on external financing to operate.
Valuations also seem to favor small-cap stocks, with earnings growth for smaller companies expected to outpace that of larger companies. As of September 16, the 12-month price-to-earnings (P/E) ratio for the S&P Small Cap 600 Index is estimated to be 16.7, compared to an estimated P/E ratio of 23.4 for the S&P 500 Index. FactSet data shows that earnings expectations for small-cap index constituents are expected to grow by about 20% in 2025, while the expected growth for the large-cap benchmark index is about 15%.
Matt Palazzolo, a senior investment analyst at Bernstein Private Wealth Management believes that, given the valuation discount, potential earnings growth, and the cyclical nature of small-cap stocks, the Fed's interest rate cut this week is likely to be a catalyst that attracts investors' attention to small-cap companies.
Although investors widely expect the Federal Reserve to begin easing monetary policy this week, the magnitude of its rate cut remains uncertain.
According to the CME FedWatch Tool, as of Monday, traders in the federal funds futures market saw a 63% chance of the Federal Reserve cutting interest rates by 50 basis points later this week, up from about 40% on Friday. They believe there is a 37% chance of a 25 basis point cut.
Jonathan Krinsky, BTIG's Chief Market Technician, said that a substantial 50 basis point rate cut could further support small-cap investments. However, there are concerns that a larger rate cut could raise alarms that the U.S. economy is slowing down more than expected, which could harm corporate earnings and the broader financial market.
However, Palazzolo said that small-cap investors should not get caught up in the debate over 25 or 50 basis points, as such a magnitude will not have a significant long-term impact on the economy.
Jay Hatfield, CEO of Infrastructure Capital Advisors and portfolio manager of the InfraCap Small Cap Income ETF, said that the recent strong performance of small-cap stocks seems to be part of the value stocks versus growth stocks narrative, which emerged when the large-cap technology stocks of the so-called FAANG group encountered resistance earlier this summer.
He noted that some small-cap indices are heavily weighted towards interest rate-sensitive and dividend-paying sectors, such as financials and real estate.
Over the past three months, the financial sector of the S&P Small Cap 600 Index has been the second-best performer among the index's 11 sectors, rising by 21.6%, while the real estate sector has risen by 18.1% during the same period.
FactSet data shows that during the same period, the financial and real estate sectors have also been among the best performers in the S&P 500 Index.