MW Small-cap stocks beating S&P 500 this quarter as investors expect Fed rate cuts

By Christine Idzelis

Small-cap-focused Russell 2000 index was rising sharply Thursday

U.S. small-cap stocks are beating the S&P 500 in the third quarter, even after being more badly battered than large-cap equities in September.

"Broadly, small caps got a lift when the Fed definitively signaled a move to easier policy" at the Jackson Hole Economic Symposium in late August, said Liz Ann Sonders, chief investment strategist at Charles Scwab, in a phone interview Thursday. "Small caps often do well in a cutting cycle," but that's generally more "pronounced" when the Federal Reserve is cutting to combat a recession and investors seek to position for their move out of one, she said.

"But we're not in a recession," Sonders said. Despite slowing, "the economy is doing pretty well," she added.

The Russell 2000 index RUT, a gauge of U.S. small-cap stocks, is up 4% this quarter even after sliding 4% this month as of Thursday afternoon, according to FactSet data, at last check. The S&P 500 SPX, a measure of large-cap stocks in the U.S., has so far seen smaller third-quarter gains of around 2.5% but is still widely outperforming small-cap equities this year.

Investors expect the Fed will announce Wednesday, after its policy meeting concludes, that it will start lowering its benchmark rate from the current elevated level held since July 2023. The Fed had hiked rates to combat a surge in U.S. inflation that peaked in 2022 and has since cooled significantly back toward its 2% target.

See: Inflation on the 'right path' despite 'slight stickiness in services,' says BlackRock's Chaudhuri

Also read: 'Inflation pipeline continues to clear' while labor market appears 'steady

Traders in the federal-funds futures market were on Thursday pricing in a 69% probability that Fed will decide to lower its policy rate by a quarter percentage point to a target range of 5% to 5.25%, according to the CME FedWatch Tool, at last check.

Investors hoping for a bigger rate cut should "be careful what you wish for," said Sonders, explaining that deeper rate reductions tend to happen in a recession or a financial crisis.

The recent rally in small-cap stocks, which generally are riskier than large-cap shares, "stalled a little bit" after traders shifted bets on the size of expected rate cuts back to a quarter percentage point from a half point, according to Sonders. That "can trigger some profit-taking in small caps because, in the aggregate, they're bigger beneficiaries of lower rates than larger companies."

'Stay up in quality'

But Sonders also cautioned that the universe of small-cap stocks is "huge" and not "monolithic."

Looking inside the Russell 2000 index, "there is still a very, very wide range in terms of performance and it generally is aligned with low quality versus high quality," she said.

"The economy is slowing, not about to accelerate," said Sonders. So, "if you want to look for opportunities" within small-caps stocks, "you want to stay up in quality."

The S&P SmallCap 600 index SML generally consists of higher-quality stocks than the Russell 2000 as it uses a "profitability filter, " according to Sonders. For that reason, she said that investors may want to use it as a base when screening for ideas.

Small-cap stocks were outperforming the S&P 500 on Thursday.

The Russell 2000 was up a sharp 1.2% in late-afternoon trade while the S&P Small Cap 600 also climbed 1.2%, both beating the S&P 500's 0.7% increase, FactSet data show, at last check.

U.S. stocks were broadly rising Thursday afternoon, with the blue-chip gauge Dow Jones Industrial Average DJIA advancing 0.5% and the technology-heavy Nasdaq Composite COMP advancing 0.9%.

So far in 2024, the S&P 500 is up more than 17% - exceeding the Russell 2000's 5% rise year to date - despite stumbling in September, according to FactSet data. The S&P 500 is down about 1% this month, while the Russell 2000 has slumped 4% in September as of Thursday afternoon.

-Christine Idzelis

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September 12, 2024 16:01 ET (20:01 GMT)

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