In the past two months, the long dormant small cap stocks in the US have been popular on Wall Street.
The latest fund manager survey by Bank of America shows that the market's bullish sentiment towards US small cap stocks has reached its highest level in nearly three years: since June 2021, fund managers have predicted for the first time that US small cap stocks will outperform large cap stocks in the next 12 months.
The biggest positive factor behind it is undoubtedly the expectation of the Federal Reserve cutting interest rates. Due to the greater impact of high interest rates on small businesses, the market is concerned that more small businesses will go bankrupt in a high interest rate environment, which has led to a sluggish performance of US small cap stocks for most of last year. This year, with market expectations for a Fed rate cut soaring, Wall Street analysts believe that the attractiveness of small cap stocks in the US, measured by the Russell 2000 Index, will continue to grow.
David Kostin, Chief US Equity Strategist at Goldman Sachs, raised his interest rate cut expectations at the end of last year and expects the Federal Reserve to cut rates for the first time in March of this year. Costin said, "For companies with weaker balance sheets, starting interest rate cuts earlier would be a welcome sign. Historically, the environment of lower interest rates and improved economic growth expectations can support small cap stocks, whose trading valuations are still relatively low."
The relatively cheap valuation is indeed another attraction of small cap stocks. Many analysts believe that the index is undervalued compared to historical standards, and even if small cap stocks have joined the upward trend since November last year, they have not yet fully caught up with the rise of large cap technology stocks, and there is still room for follow-up gains.
Lori Calvasina, a strategist at RBC Capital Market, has been recommending small cap stocks for the past few months. In December last year, she said, "Since the bursting of the technology foam in 2000, the Russell 2000 index has never been so cheap compared with the S&P 500 index. This is bound to draw the attention of some multi asset investors to small cap stocks."
At that time, Tom Lee, the head of research at Fundstrat, an investment research firm, also predicted that the US stock market's large cap technology stocks would continue to perform well in 2024, but would underperform smaller cap stocks. "Small cap stocks may easily rise by 50% in 2024, while financial stocks (XLF) may rise by 30%. This is because from the position situation, it can be seen that not many people hold financial stocks, nor do they hold and long small cap stocks, so there is a lot of upward space for these two sectors in the future," he said.
In fact, since Li made the prediction, the market has undergone changes. Due to the faster decline in inflation than previously predicted by the market, the market has been increasing its bets on the Federal Reserve's interest rate cut this year since the last two months of last year. Currently, it has risen to 5-6 times and has been re pricing the market based on this. Driven by this, according to data from Bespoke Investment Group, the Russell 2000 index rose from a 52 week low to a 52 week new high in just 48 days from late October to mid December last year, marking the fastest reversal in the index's history. At present, the index has accumulated an increase of over 16% from the low point in October last year.
After a wave of gains, the key question investors are currently facing is whether the index has fully absorbed the benefits of lower future interest rates, thereby limiting the potential for subsequent gains.
In Costin's view, the answer is no. In his research report on January 12th, he wrote, "The combination of still low valuations and a healthy economic outlook means that the Russell 2000 index's return rate in the next 12 months will reach about 15%." However, he also warned that if "investor expectations for economic growth deteriorate," the situation may change.
Kawasina also stated that the supporting factors for her previous bullish view on small cap stocks still exist, namely, "small cap stocks have performed well in previous interest rate reduction cycles, and their risk exposure to higher interest rates is not as bad as the market had previously feared.". In her latest research report on January 8th, she stated, "Since December last year, everyone we met, including many investors who never focused on investing in small cap stocks, wanted to talk about small cap stocks and have a constructive attitude towards them. I can't remember when this happened last time."