Russell 2000 Rising Sharply, It Could Be Time for Small-Cap Stocks to Sparkle

What factors have contributed to this sharply rising in small-caps? Due to the cooler-than-expected October CPI report and expectations of interest rate cuts next year, it’s time for Small-Cap Stocks to sparkle.

The US October CPI slowed materially from the previous month, headline CPI came in at 3.2%, below the 3.3% expected, while MoM CPI also missed expectations, printing unchanged (0.0%), below the consensus of a 0.1%, and sharply below last month's 0.4%.

The core CPI October MoM was 0.2%, below the 0.3% consensus estimate and down from the 0.3% increase in Sept, with YoY managed to drop from 4.1% to 4.0%, which is the lowest since Sept 2021!

The rapid cooling in US inflation supports the view that the Federal Reserve may have completed its interest rate hikes.

CME FedWatch shows that traders now expect 92 basis points of rate cuts next year, several analysts predict that the continued downward trend in inflation will lead the Federal Reserve to start cutting interest rates as early as March of next year.

A benign U.S. inflation report is bolstering hopes that the Federal Reserve can bring down consumer prices without hurting the economy, a so-called Goldilocks environment.

Inflation data released on Tuesday supported the Goldilocks view: consumer prices were unchanged on a monthly basis for October, the first such reading in more than a year and a softer figure than analysts were expecting.

At the same time, there have been few indications that tighter monetary policy is severely hurting the economy, backing the idea that prices can cool further without damaging growth.

"The broader market has been challenged with this consensus negative view about both a recession and inflation," said Eric Kuby, chief investment officer at North Star Investment Management Corp. "Reality is telling a different story. This does feel like a Goldilocks moment for the entire market.”

With the Russell 2000's forward price-to-earnings ratio falling to a 14-month low, BofA analysts led by Jill Carey Hall noted that for long-term investors, it implies a 12% annualized price returns over the next decade versus 7% for the large cap Russell 1000 Index.

Small caps remain historically cheap, trading at a 19% discount from their typical valuations. By comparison, mega-cap shares have an 18% premium and large caps have a 12% premium, according to BofA.

Of course, index construction also matters in assessing the strength of US small- and mid-cap stocks.

"S&P indices will have a higher quality element while Russell benchmarks (particularly for small cap) face a negative earner issue," Scott Chronert, US equity strategist at Citigroup wrote in a note. The Russell 2000 has a large component of mostly unprofitable biotech firms, whereas the S&P has little of that exposure.

While the earnings expectations for small- and mid-cap companies earnings aren't as robust as they are for big caps, Chronert thinks they may be an interesting substitute for a "value" allocation in a portfolio. He suggests looking at the S&P 1000 Index, which combines small and mid caps and has a relatively high correlation to S&P 500 equal weight and enhanced value indexes - is delivering stronger earnings.

Source: Bloomberg, ZeroHedge, Reuters