US small-cap stocks have seen a strong rally amid expectations of lower interest rates and an improving outlook for Donald Trump, the Republican presidential nominee known for his support for policies that favor small domestic companies.
The Russell 2000 (.RUT), an index of small companies, has risen more than 11.5% over the past five days, its biggest gain in that time frame since April 2020.
However, technology and growth stocks have been choppy, supporting the view that small-cap stocks have benefited from investors shifting away from this year's best-performing companies to less popular parts of the market.
The selloff in tech stocks has intensified this week after reports that the U.S. is considering tougher restrictions on chip exports to China and after Donald Trump's comments on Taiwan raised geopolitical concerns about the sector.
The Nasdaq 100 tech index (.NDX) has fallen 3% since last week, including its biggest one-day drop this year on Wednesday. The S&P 500 (.SPX), typically used as a benchmark for large-cap stocks, rose 0.2%.
"The landscape has changed," said Eric Kuby, chief investment officer at North Star Investment Management Corp., a small-cap firm. "I'm hopeful that this rally over the past week is just the beginning of a multi-year period where small companies can gain significant ground."
Smaller stocks have been sliding for months as investors pile into the big tech stocks that have dominated the market for much of 2024. Despite the recent jump, the Russell 2000 is up only 10.5% year to date, while the S&P 500 is up 17% and the Nasdaq 100 is up nearly 18%.
That changed last week, when weak inflation data raised expectations that the Federal Reserve will cut interest rates in the coming months, which could benefit smaller companies struggling with high borrowing costs.
The rally, fueled by the failed assassination attempt on Trump over the weekend, appears to have increased expectations that he will win the election. His proposals to increase tariffs and cut taxes could benefit small companies.
Among the small-cap names that posted big gains after last week's inflation data were biotech Caribou Biosciences (CRBU.O), up 55%, construction company Hovnanian Enterprises (HOV.N), up more than 30%, and insurance company Hippo Holdings (HIPO.N), up more than 29%.
The continued outflow of funds from the tech sector, fueled by concerns about lofty valuations and possible similarities to the dot-com bubble of two decades ago, could strengthen the position of small-cap stocks.
The Russell 2000 index currently has a market value of $2.7 trillion, according to LSEG. By comparison, the Big Three, Microsoft (MSFT.O), Apple (AAPL.O) and Nvidia (NVDA.O), each have a market capitalization of more than $2.9 trillion.
Historically, small-cap stocks have been gaining at least 1% in the short term. The Russell 2000 last gained at least 1% in five consecutive sessions, which has happened only four times, according to Bespoke Investment Group.
After those streaks, the index has averaged a 5.9% gain over the next month, according to Bespoke.
While the S&P 500 has hit record highs this year, the Russell 2000 is still about 8% below its 2021 peak, suggesting room for more gains in small-caps.
Retail investors have also been snapping up stocks. Analysts at Vanda Research have said the influx of money into small-caps has caused a "short squeeze." In this process, rising prices force bearish investors to cover their bets against the stock, pushing it higher.
"We believe there is scope for retail investors to continue to participate in this race over the next 1-2 weeks," the analysts said.
Small-cap investors have repeatedly been disappointed after periods of growth. For example, hopes for interest rate cuts sent the Russell 2000 index up more than 20% from late October to late December 2023. However, the index retreated in early 2024 when no rate cuts materialized.
The upcoming earnings season may provide more of a case for small caps. Russell 2000 companies are expected to post 18% earnings growth in the second quarter, according to LSEG.
Meanwhile, mega-caps will also have a chance to regain their lead when giants like Tesla (TSLA.O) and Alphabet (GOOGL.O) report next week.
Brokerage Edward Jones maintains a "neutral" outlook on small-caps, waiting to see if they can post stronger earnings growth, said Angelo Kourkafas, senior investment strategist at the firm.
Experts say a more positive outlook for small-caps over the long term requires either a significant improvement in earnings or a pickup in economic activity.
A bearish mood is also expected in European markets. The pan-European STOXX 600 tech index (.SX8P) is set to return to focus after posting its biggest one-day drop since December 2022, led by ASML (ASML.AS).
Chip investors are concerned about Washington's tougher stance on the U.S. semiconductor industry, which the U.S. sees as strategically important to competing with China.
Bloomberg reported Wednesday that the U.S. has warned its allies of the possibility of imposing the toughest trade restrictions yet if companies continue to provide China with access to advanced semiconductor technology.
That, along with Republican presidential candidate Trump's suggestion that Taiwan should pay the U.S. for its defense, sent chipmaker stocks tumbling, wiping out more than $500 billion in market value.
Chipmaker stocks have fueled a global equity rally this year, helping push the Nasdaq (.IXIC) and S&P 500 (.SPX) to record highs. Some analysts believe the recent moves are due to investors adjusting their positions.
In Asia, attention will be focused on TSMC's (2330.TW) earnings report on Thursday. The stock has fallen more than 6% over the past two days.
Meanwhile, the European Central Bank's policy meeting is set to be a key event later in the day. The central bank is expected to keep interest rates on hold, with comments from officials likely to hint at a possible rate cut.
The comments are likely to weigh on the euro, which hit a four-month high on Wednesday. Traders have fully priced in a 25 basis point Federal Reserve rate cut in September following comments from Fed officials.
The yen also wavered after hitting its highest in six weeks on Thursday. Traders remain wary after Tokyo's intervention last week was expected to reach nearly 6 trillion yen ($38.4 billion), according to the Bank of Japan. Official spending figures are expected later this month.
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