Small-Caps Are Having a Moment. Why the Russell 2000 Rally Faces a Tough Road.

The Russell 2000 small-cap rally has been impressive, but its prospects are doubtful. Above, a scene from the trading floor of the New York Stock Exchange. (NYSE)

The Russell 2000 could hit its first record high in nearly four years over the coming days as investors continue to pile cash into small-cap stocks amid the broader market’s monthslong rally. Don’t expect it to last.

The Russell 2000 has risen around 2.3% so far this month, following on from its best August performance compared with the S&P 500 in nearly a year. Improving earnings and the prospect of Federal Reserve rate cuts are attracting more investors to the small and mid-cap benchmark.

Friday morning, the index was just 35 points from the record high of 2442.74 it reached on Nov. 8, 2021. It was around 60 points short of the intraday peak reached in November of last year. That is striking because the index has gone 964 days without closing at a record, its second-longest streak, while the S&P 500 has done so 24 times this year alone.

Investors see the potential for more gains, partly because of monetary policy. The CME Group’s FedWatch Tool indicates investors expect at least three quarter-point interest-rate cuts from the Fed over the next three months. Prices of interest-rate futures point to the central bank’s lending rate falling to between 3% and 3.25% from 4.25%-4.5% now by this time next year.

Small-cap stocks tend to benefit more from lower Fed rates because smaller companies rely more heavily on bank lending than the bond market to fund their businesses. Bank rates move in lockstep with the Fed’s move, while yields on bonds, which bigger companies use to raise money, are influenced by a variety of other factors, such as inflation.

Collective earnings from the benchmark’s 2,000 constituents, meanwhile, are forecast to grow by more than 50% on average over the next four quarters, nearly five times the pace of S&P 500 profits, based on LSEG estimates.

“Small-caps should increasingly have an earnings growth edge over large-caps,” said Jason Pride, chief of investment strategy and research at Glenmede. “They’re also likely to benefit more from corporate tax relief and lower interest rates while also being less exposed to the impact of tariffs.”

And they are still cheap by comparison. The Russell 2000’s forward price/earnings ratio, which measures what an investor is paying for each dollar of future earnings, is at around 16.1 times. The S&P 500 is near a historical high at around 23 times.

A problem is that calculating the Russell 2000’s value based on only the constituents posting profits pegs its P/E ratio at around 33 times, based on Wall Street Journal estimates. That suggests a longer-run advance for the benchmark could be tricky. Broader concerns over the health of the U.S. economy, tied in part to weakness in the labor market, are a risk for profit growth.

“We think it will be difficult for small-caps to sustain any kind of major, durable outperformance trade as long as economic sluggishness remains the norm,” said Lori Calvasina, head of U.S. equity strategy at RBC Capital Markets, in a recent client note.

In fact, Calvasina says that investors moving out of small-cap stocks, which would drag down the Russell 2000 and widen the P/E gap between it and the S&P 500, “may also end up being a useful signal for when the broader U.S. equity market is ready to take a breather.”

Adam Turnquist, chief technical strategist at LPL Financial, also cautions that a good portion of the Russell 2000’s recent gains, which have more than doubled that of the S&P 500 since the beginning of August, could be paradoxically linked to bets against it.

“The rally in small-caps has caught many off guard—and on the wrong side of the trade for many speculators in the hedge fund space,” he said, noting that data from the Commodity Futures Trading Commission shows the largest short positions held by hedge funds and other big players since 2022.

“With trend and momentum remaining bullish, the prospect for a short-covering rally tailwind for small-caps remains high,” he said. “But as exciting as the recent price action in small-caps has been, we remain skeptical of sustainable outperformance on a longer term basis.”

Write to Martin Baccardax at martin.baccardax@barrons.com