Small Caps: The Hottest Investment Now

Futures indicate a positive start for equities, with the S&P 500 nearing a record high.

Despite recent calm, analysts detect a significant shift in market sentiment. Greg Boutle of BNP Paribas notes that last Thursday’s softer-than-expected consumer price index report and the resulting dip in Treasury yields triggered a major rally in overlooked market segments. Small-cap stocks gained favor, while Big Tech faced heavy selling.

Though this trend partially reversed on Friday, the key question is whether small caps will maintain their upward momentum.

Tom Lee of Fundstrat is optimistic. He believes small caps, tracked by the iShares Russell 2000 ETF (IWM), present the “most compelling near-term investment case,” predicting a potential 50% gain in 2024. With small caps currently up only 6%, there is significant growth potential. Lee attributes this to the low June CPI, which he believes signals continued small-cap rallies.

Lee’s optimism is based on five key factors:

1. Interest Rate Cuts: The probability of a 25-basis-point rate cut by the Federal Reserve in September is around 95%. Smaller companies, which are more sensitive to borrowing costs, would benefit greatly from such a cut.
2. Historical Performance: The IWM surged about 27% from October to December last year when the Fed paused rate hikes. Lee anticipates a larger and longer rally with an actual cut.
3. Improving Sentiment Towards Regional Banks: Regional banks, which have a significant weighting in the IWM, are seeing improved sentiment. The SPDR S&P Regional Banking ETF (KRE) has recently broken out to the upside.
4. Lower Inflation Expectations: Lee argues that investor inflation expectations are too high and will lower, providing a boost for small caps.
5. Narrowing Quality Spread: The narrowing yield spread between lower-rated small-cap debt and higher-rated large-cap debt indicates growing investor confidence in small caps, which typically leads to their outperformance.

“We see the conditions for a strong rally in IWM. Mark Newton, head of technical strategy, believes a confirming ‘breakout’ of small caps could happen this week,” concludes Lee.