After years of poor performance, small cap stocks have recently experienced good times. But can this situation continue? A new study by Bank of America outlines two specific criteria that can serve as signals that small cap stocks will continue to rise.
The bank pointed out that the yield of 10-year US treasury bond bonds must remain below 4%, and the ISM purchasing managers' index (PMI) must rise above 50.
Bank of America stated that in the past, when these two signals appeared simultaneously, the S&P 500 weighted index (SPW) was superior to the market capitalization weighted index (SPX), which was more susceptible to the influence of mega tech stocks. SPW is considered a good reflection of the strength of small cap stocks.
Citing the figure below, analysts of Bank of America wrote: "Historically, when the yield of 10-year treasury bond bonds fell more than 1 percentage point from a 12-month high (3.99% today) and the ISM PMI rose more than 4 points from a low point (50.5 today), the performance of SPW was 6.3 percentage points higher than SPX on average in 90% of cases."
After the unexpected cooling of inflation data in June, small cap stocks gained growth momentum, which strengthened market expectations of an upcoming interest rate cut. Investors currently believe that there is an 88.5% chance that the Federal Reserve will begin easing policy in September. With this in mind, investors have become more eager for industries that are expected to benefit from lower borrowing costs.
Wall Street has different opinions
The Russell 2000 Index, which is dominated by small cap stocks, has shown signs of recovery, soaring more than 10% so far in July. For most of this year, high interest rates and a frenzy for trading large tech stocks have suppressed the upward momentum of the Russell Index. But as investors began to snap up this overlooked index, some believed it was evidence of widespread market volatility.
Tom Lee, co-founder and head of research at Fundstrat Global Advisors, a US investment firm, said last week: "I think August will really be a month where the rotation becomes more apparent. I think small cap stocks will strengthen, and the S&P 500 index may remain flat or just decline slightly." He expects the Russell index to rise 40%.
Others are not so sure.
Barclays found that small cap stocks typically do not outperform the S&P 500 index after the first interest rate cut. The analyst of the bank stated that in fact, the Russell Index has a downward trend.
And currently, neither of the two standards mentioned by Bank of America has been met, which cannot support a longer period of upward trend. Although the yield of 10-year treasury bond has gradually declined since its peak in May, it still remains above 4%. Meanwhile, the manufacturing PMI for June has dropped to 48.5.
The manufacturing economy is in the second longest period of downturn in history, with no consecutive two months of PMI exceeding 50 in the past 21 months. We believe that this is largely due to the destocking cycle, and we expect the destocking cycle to ease in the second half of the year, "wrote the Bank of America analyst.