Small-cap stocks surge as tech falters

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The sell-off in the tech-heavy Nasdaq and semiconductor shares has resulted in a significant shift in investor focus from megacap tech stocks to smaller companies and other sectors. The Russell 2000 small-cap index has seen a dramatic 7 percent rise since last Thursday, buoyed by an improving earnings outlook. Notably, the so-called “Magnificent Seven”—the megacap stocks responsible for driving the gains in the S&P 500 over the past year—have experienced losses. These declines were intensified by a global sell-off in semiconductor companies.

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In contrast, stocks in financials, energy, and real estate sectors have performed well, leading a climb in the majority of other S&P 500 stocks. “All of a sudden, we have a larger menu to choose from, whereas last year there was really only one thing on the menu,” remarked Jurrien Timmer, Director of Global Macro at Fidelity.

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“When you have a more broad-based earnings recovery and a Fed pivot at the same time, and the bond market is being well-behaved, there are other things to buy now too.” The S&P 500 index advanced by 14 percent in the first half of 2024, although this was driven by a narrow group of large companies, raising concerns about rally sustainability. For active fund managers, the narrow rally posed challenges in keeping up with benchmarks due to over-reliance on a few outperforming stocks. Last week’s inflation data strengthened investor expectations of a Federal Reserve interest rate cut in September. Smaller companies in the Russell 2000, which often have higher debt burdens, have particularly benefited from this shift in expectations. Gains over the past week have been broad-based, with more than 1,500 of nearly 2,000 companies in the Russell index rising. The equal-weighted S&P 500 outperformed its cap-weighted counterpart by climbing almost 3 percent, while the latter fell.

Small-cap stocks gain momentum

Analysts at Bank of America observed that short covering was a notable driver of the Russell 2000’s rally, with heavily-shorted stocks performing well. I think a lot of people were caught offside,” said Brandon Nelson, a portfolio manager at Calamos focusing on small- and mid-caps. “Although the Magnificent Seven and AI-linked stocks still have growth potential, their earnings growth relative to the market may wane,” commented Jim Tierney of AllianceBernstein. While many investors have anticipated a broadening of gains, there are concerns for the overall index’s performance. The S&P 500 index fell by 1.5 percent despite more than 350 stocks rising in the week following the inflation data release, driven by the heavy weighting of the largest tech stocks. Whether the market can continue its upward trajectory remains to be seen. Investors are watching closely to see if new money flows into stocks outside the Magnificent Seven, or if this rotation is solely internal. Several analysts also emphasized the delicate balance needed for smaller companies to continue rising. They require the Federal Reserve to cut rates without triggering an economic downturn that could harm earnings. For example, Thursday’s data showing jobless claims at the highest level since 2021 resulted in a 1.9 percent drop in the Russell 2000. Despite recent gains, small-caps and the equal-weighted S&P 500 are still lagging behind the benchmark S&P 500. “You’ve closed the gap a little bit in the last week,” said Nelson at Calamos, “But you can’t undo years of underperformance in five days.”