Small-cap stocks, as indicated by the Russell 2000 Index, have lagged their bigger peers so far this year. Small-cap exchange-traded fund (ETF) iShares Russell 2000 IWM is up about 3.7% this year compared with gains of about 10% in the S&P 500, 13% in the Nasdaq-100 ETF QQQ and 5% in the Dow Jones.
And why not? While higher borrowing costs have weighed on the small caps’ capital expenditure, inflationary fears have dampened consumer confidence. After such a lackluster performance, can small caps turn around? Let’s delve a little deeper.
Fed Chair Jerome Powell initially feared that Trump’s tariffs would raise inflation considerably. So far, the data suggests otherwise. The latest CPI report came in better than expected, sparking a sharp rally on Wall Street.
The Consumer Price Index (CPI) increased 0.2% sequentially and 2.7% year over year, according to the Bureau of Labor Statistics (BLS). This compares with Dow Jones’ forecasts of 0.2% monthly and 2.8% annual growth, as quoted on CNBC.
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Excluding volatile food and energy prices, core CPI rose 0.3% in July and 3.1% annually, in line with monthly expectations but slightly above the 3% yearly forecast. Following the bullish inflation print, Polymarket now places the probability of a 25 bps Fed rate cut on Sept. 17 at 81% (read: Less-Than-Expected Inflation in July: Growth ETFs to Gain?).
Small-cap companies are more debt-dependent than their mega-cap counterparts, meaning lower interest rates directly reduce their borrowing costs. Rate cuts also tend to stimulate domestic growth—a key revenue driver for smaller firms.
High rates have kept small caps out of favor, but with Nasdaq valuations looking rich and the Russell 2000 still trading at reasonable levels, a rotation could be in the cards. If overbought tech takes a breather, small caps may be up for a rally.
In terms of book value, the S&P 500 is trading at five times book value compared to only two times for the Russell 2000. These valuation differences indicate that small-cap stocks are currently undervalued, per a CME Group article.
The Small Business Optimism Index, as reported by the NFIB, increased by 1.7 points in July to reach 100.3, slightly surpassing the index’s long-term average of 98. The rise was fueled by improved business conditions and greater belief in the potential for business expansion.
