Small-cap U.S. stocks, which the index represents, have outperformed the S&P 500 by more than 10% since early July, driven by expectations of a Federal Reserve rate cut and market speculation about the upcoming election.
For an asset class that has consistently underperformed for most of the past decade, this sudden rebound has raised questions about the sustainability of the small-cap rally.
In a report published Monday, Wells Fargo analysts offered a cautious outlook, noting that similar increases in small-cap stocks tended to be short-lived.
Historical trends support this view, with previous spikes often triggered by specific events, such as the 2016 election, the start of the tariff campaign in 2018, and the fourth quarter 2023 shift from fear of Fed rate hikes to anticipation of large cuts.
“Each of these small-cap price surges relative to large-cap stocks had similar catalysts, and relative returns failed to develop into sustained small-cap outperformance,” Wells Fargo analysts said. “We suspect the current iteration will follow a similar pattern.”
Analysts also point out that fundamental support for these stocks is lacking.
Specifically, they said the Russell 2000 remains in a state of earnings stagnation, raising doubts about the sustainability of this uptrend. Consensus earnings estimates for the small-cap index continue to decline, and more than 40% of companies in the Russell 2000 are not profitable.
Moreover, small-cap companies generally lack the balance sheet flexibility and pricing power that large-cap companies typically benefit from in the current economic environment, and with the economic slowdown expected in the near term, the group is likely to face additional pressures, according to the Wells Fargo team.
“We suggest investors do not chase the recent outperformance of small-cap US stocks,” the note said.
“Similar to previous sentiment-driven rallies, we suspect the recent rally in small-cap stocks is unsustainable.”
U.S. stocks started August sharply lower after economic data released on Thursday raised concerns of a faster-than-expected economic slowdown, even as the Federal Reserve continues its tightening monetary policy.
The Russell 2000 index of small-cap stocks fell 3.03%, marking its biggest daily decline since Feb. 13. Small-cap stocks were volatile as investors shifted between cheaper and more expensive stocks.
“Without a good economy, these economically sensitive small-cap stocks won’t do much, even with interest rate cuts,” said market analysts at Interactive Brokers.
Stocks initially opened higher, but those gains later faded after data revealed that the Institute for Supply Management’s (ISM) manufacturing activity gauge fell to an eight-month low in July at 46.8, indicating contraction.
Historically, August is one of the weakest months of the year for stocks.