Rotation from tech winners to Russell, small-cap still has 'ways to go': analysts

U.S. small-cap stocks are staging a long-awaited comeback, driven by expectations of interest rate cuts and improving prospects for Republican presidential candidate Donald Trump, whose policies are seen as favorable to smaller domestic companies.

The Russell 2000, which tracks small-cap stocks, jumped more than 11.5% over five days, marking its biggest gain over such a period since April 2020.

Meanwhile, tech and growth stocks have faltered, pointing to a rotation out of this year’s top performers into undervalued market areas.

The tech-heavy Nasdaq 100 has fallen 3% since last week, including its largest one-day drop of the year on Wednesday. The S&P 500, a benchmark for large-cap U.S. stocks, is up just 0.2%.

Analysts weigh in on the rally in small-caps

Shares in smaller companies have struggled for months as investors favored massive tech stocks that have driven indexes for most of 2024.

Despite the recent surge, the Russell 2000 is up only 10.5% this year, compared to a 17% gain for the S&P 500 and nearly 18% for the Nasdaq 100.

The outlook changed last week when a softer-than-expected inflation report raised expectations that the Federal Reserve will cut rates in the coming months, potentially benefiting smaller companies burdened by high borrowing costs.

But even with the recent outperformance of small-cap shares, the valuation gap remains significant, Citi analysts noted.

The trailing multiple spread between the Russell 2000 and the Russell 1000 has narrowed but is still in the 15th percentile relative to the past 20 years. Forward multiples show a similar trend, with the S&P 600 – S&P 500 one-year forward price-to-earnings (P/E) spread remaining in the bottom decile even after the recent movement.

"In our view, if confidence is building that we can get to looser Fed policy without a recession, repositioning may still have a ways to go,” Citi analysts said.

Meanwhile, UBS analysts said the rotation into small-caps could continue given the slowing mega-cap tech earnings.

“News regarding potential curbing of chip exports supporting the recent rotation out of Growth. While the momentum trade has started to roll over, we do not see evidence of a full-on momentum unwind just yet,” they wrote.

“We think there is room for the rotation into low quality to persist if rate cuts remain priced and the Trump 2.0 trade carries on ahead of US elections.”

Also weighing in on this matter, analysts at Bank of America believe the focus now may shift to fundamentals as the second-quarter earnings season begins.

They note that estimates have continued to decline, with the percentage of EPS and sales beats being lackluster, and revisions remain weakest among small-cap stocks.

"Lack of improvement could suggest a pause in outperformance, but if we see better guidance/revisions, the rally likely continues,” BofA highlighted.

Lastly, Wells Fargo’s team of analysts said that while the focus has mainly shifted to small-caps, Midcap Growth "offers the best risk/reward due to valuation, technicals, leverage, and earnings stability."

They highlighted that S&P Midcap Growth is outpacing the Russell 2000 nearly matching the S&P 500’s gain of 18%.