For much of 2024, small-cap stocks have been left in the dust by their larger brethren, particularly the high-flying tech giants. However, a recent shift in market sentiment suggests this trend may be reversing. In a surprising turn of events, small caps surged on Thursday, leaving many hedge funds scrambling after they had placed significant bets against them.
This article explores the factors behind this sudden rally and what it could mean for the future of small caps.
Hedge Funds Caught Short as Small Caps Surge
Market data suggests that hedge funds and other sophisticated investors may have been caught off guard by the recent surge in small caps. According to a report by Bespoke Investment Group, short positions against the Russell 2000 Index, which tracks small-cap stocks, had been increasing rapidly in recent weeks. This suggests that many investors were anticipating further underperformance for small caps.
However, Thursday’s release of the Consumer Price Index (CPI) data, which showed inflation declining for the first time since the pandemic, triggered a market rotation. Investors dumped tech stocks, which are seen as more sensitive to rising interest rates, and flocked to small caps and other sectors that could benefit from a potential rate cut by the Federal Reserve.
This sudden shift caught many hedge funds flat-footed, forcing them to unwind their short positions and buy back into the market, which likely contributed to the upward momentum for small caps.
Beyond the Short Squeeze: Reasons for Optimism on Small Caps
While the short squeeze undoubtedly played a role in Thursday’s rally, there are other reasons to be cautiously optimistic about the near-term prospects for small caps.
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Historically Low Valuations: Compared to large caps, small caps are currently trading at historically low valuations. This makes them attractive to bargain-hunting investors looking for undervalued opportunities in a generally expensive market. Data from FactSet shows that companies in the Russell 2000 are valued at a fraction of their large-cap counterparts, creating a significant valuation gap.
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Potential for Earnings Boost from Rate Cuts: An analysis by Jefferies suggests that small caps tend to outperform large caps during the first year after the Fed lowers interest rates. This is because lower borrowing costs can improve small businesses’ profitability and make it easier for them to manage their debt. With inflation showing signs of cooling, expectations for a rate cut are rising, potentially benefiting small caps.
Is a Broader Rotation Coming?
The recent outperformance of small caps could be the start of a larger rotation away from growth stocks and towards value stocks. Small caps are typically seen as more value-oriented compared to their large-cap counterparts, and their lower valuations suggest they may have more room for growth.
Market strategist Jordan Irving of Glenmede Investment Management believes a rotation is certainly possible, given the more attractive valuations of small caps. He highlights that small caps are “spring-loaded” for growth due to their current valuations compared to large caps.
Conclusion
While the future remains uncertain, the recent surge in small caps is a positive sign for this long-underperforming sector. With historically low valuations, the potential for a rate cut, and a possible rotation away from growth stocks, small caps could be poised for a comeback. However, investors should remember that past performance is not necessarily indicative of future results, and a sustained rally will depend on factors such as company earnings growth and overall market conditions.