The Zhitong Finance App learned that although soaring US bond yields and rising borrowing costs have continued to suppress US small-cap stocks recently, the resilience shown by the US economy is strengthening its rebound logic. Bank of America pointed out that for small-cap stocks that are highly dependent on the local US economy, the manufacturing industry is the most important macro indicator affecting their relative performance, and the latest data shows that the US manufacturing industry has been expanding for nine consecutive months, the longest expansion cycle since 2022. Meanwhile, the valuation of small-cap stocks fell to a four-month low, and the revenue and profit growth rate in the next few quarters is also expected to surpass that of large stocks.
Bank of America strategist Jill Carey Hall said that judging from the historical level, US small and medium capitalization stocks are currently “very cheap” compared to large and very large stocks. She pointed out that valuations are not necessarily a good indicator for judging the timing of short-term entry, but in the long run, their predictive ability is usually stronger.
This view is particularly noteworthy for small-cap investors who have recently experienced a clear correction. More than two-thirds of the revenue from the Russell 2000 Index's constituent stocks comes from within the US, so they are more sensitive to the US economy and manufacturing cycle. According to the data, in the three months up to the end of September, the Russell 2000 index had a cumulative decline of 7.5%. The performance compared to the S&P 500 index was one of the second-worst quarters of this century.
The recent pressure on small-cap stocks is mainly affected by factors such as continued inflationary pressure, the Federal Reserve's interest rate hike, and the sharp rise in US Treasury yields. For small-cap companies that usually have higher financing needs and financing conditions are weaker than those of large enterprises, rising interest rates mean higher debt repayment and refinancing costs, and are therefore more sensitive to changes in interest rates.
The upcoming earnings season could be another catalyst for a rebound in small-cap stocks. Bloomberg industry research strategist Nathaniel Welnhofer pointed out that the index measuring the increase and decrease in revenue expectations for the constituent stocks of the Russell 2000 Index is currently close to the highest level since 2022, indicating that analysts' views on the revenue prospects of related companies are improving.
Looking ahead to the third quarter, the market expects the average revenue growth rate of small-cap stocks in the next four quarters to be 11.2 percentage points higher than that of the S&P 500 index constituent stocks, and the profit growth rate is also expected to surpass that of large stocks.
At the same time, the balance sheet situation of small-cap companies has also improved compared to the past. According to data from Jefferies strategist Steven DeSanctis, the current debt-to-capital ratio of the constituent stocks of the Russell 2000 Index is about 33.9%, the lowest level since 2021. Lower levels of leverage mean that some companies are more able to cope with a high interest rate environment than in the past.
However, the recent trend of small-cap stocks still clearly lags behind large technology stocks. The Russell 2000 Index fell 0.6% on Tuesday, a cumulative drop of 7.8% from the all-time high set in August; in contrast, the S&P 500 Index and the Nasdaq 100 Index rose 0.6% and 0.5% respectively on the same day, both of which hit record closing highs.
Seasonal factors have also previously put pressure on small-cap stocks. Since entering this century, September has been the worst month for the average performance of the Russell 2000 Index, with an average decline of 1.3%. The index fell 5.4% in September this year, the worst September performance since 2023.
For investors who expect small-cap stocks to regain upward momentum in the next few weeks, Susquehanna strategist Christopher Jacobson suggests focusing on the iShares Russell 2000 ETF (IWM.US) $290/300 bullish option spread strategy due at the end of October. However, the options market has yet to show clear one-sided optimism. The indicator that measures the difference in demand between bullish options that bet on a 10% rise in Russell 2000 and put options that prevent a similar decline is only slightly above the historical average, which means that the overall mood between long and short is still relatively balanced.
Interest rate trends are still one of the biggest variables that determine whether small-cap stocks can actually reverse their decline. Although the S&P 500 index has so far withstood the pressure brought about by the 10-year US Treasury yield rising to near the high level since 2002, the impact on small-cap stocks is even more obvious.
DeSanctis believes that if 10-year US Treasury yields continue to rise due to positive factors such as accelerated economic growth, small-cap stocks are still likely to outperform the market. Therefore, investors will pay close attention to the Federal Reserve's next interest rate meeting at the end of October and the upcoming September monetary policy meeting minutes. At the September meeting, the Federal Reserve raised interest rates for the first time in three years.
Welnhofer said that the current constraints on small-cap stocks are basically similar to other companies that have excluded large technology stocks from the S&P 500 index. Strong performance in the upcoming earnings season may provide support for small-cap stocks and even the broader US stock market; otherwise, investors may need to wait for the Federal Reserve to release more moderate policy signals before seeing small-cap stocks gain more sustained momentum to rebound.