Wall Street’s small-cap stocks have joined the surge.
After the Federal Reserve resumed lowering interest rates after a nine-month hiatus, small-cap stocks appear to have finally roared back, raising expectations that lower borrowing costs could bring life to one of the stock market’s most underappreciated sectors.
However, a closer look reveals that the small-cap rally isn’t quite as robust or wide as it seems.
Despite hovering close to record territory this month, small-cap stocks, as measured by the Russell 2000 index RUT, are now less appealing in terms of value due to the rise. According to certain metrics, small-cap stocks now appear nearly as frothy as their large-cap counterparts, casting doubt on the widely held belief in the market that years of poor performance have made them attractive to investors seeking growth.
According to Dow Jones Market Data, the iShares Russell 2000 ETF IWM closed Friday at a forward price-to-earnings ratio of 24.64, while the iShares Russell 3000 ETF IWV and the large-cap SPDR S&P 500 ETF Trust SPY were trading at 22.32 and 22.50, respectively.
According to Dow Jones Market Data, the iShares Russell 2000 Growth ETF IWO traded at an even frothier level on Friday, with a forward P/E of 36.38.
Concerns are heightened by the fact that a limited number of growth and technology stocks, rather than a broad spectrum of small-cap firms, have driven the surge.
The information-technology (XX:SP600.45) and consumer-discretionary (XX:SP600.25) sectors have led the charge, up 12.7% and 10.9%, respectively, so far this quarter. The S&P Small Cap 600 has increased 8.3% during the same time period, according to FactSet data. This is a breakdown of the 11 sectors that make up the S&P Small Cap 600 index SML.
According to FactSet, the majority of other sectors have hardly moved, although two additional cyclical sectors, industrials XX:SP600.20 and energy XX:SP600.10, have also reported double-digit gains since August, up 10.9% and 13.7%, respectively.
Indeed, small-cap growth names have been the main driver of the small-cap universe, much like megacap technology firms have dominated the gains in the large-cap market. According to Dow Jones Market Data, since its debut in April 2010, the Invesco S&P Small Cap Information Technology ETF PSCT has beaten the S&P 600 small-cap index by an average of 1.25 points over every given 100-day holding period.
“Tech stocks have had an incredible run, and it makes us nervous as it feels like an escalator ride on the way up and then an elevator on the way down, so we’re nervous about the technology sectors, both for small caps or large,” Sandy Villere, portfolio manager at Villere & Co., said
Due to their greater reliance on outside funding for business operations, small-cap companies are generally more susceptible to fluctuations in borrowing costs than their large-cap counterparts. This is why this specific set of equities has benefited from the Fed’s rate decrease last week as well as the potential for additional rate cuts later this year and in 2026.
It’s not a one-size-fits-all situation, though.
Despite producing no revenue this year, some of the biggest stocks in the Russell 2000 index have seen their value soar.
For instance, the shares of Oklo Inc. (OKLO), one of the biggest components of the Russell 2000, have increased by almost 100% so far this quarter. Since investors flocked to the nuclear-tech company in anticipation of its possible role in enabling AI data centers with small modular responses, Oklo has amassed an impressive $16.3 billion market valuation, making it one of the largest prerevenue firms listed in the United States.
Wall Street does not expect Oklo to generate revenue until the fourth quarter of 2027, according to FactSet. The firm will not begin commercial operations until late 2027 or early 2028, but it is anticipated that it will submit an application for a license to construct its first 75-megawatt power plant to the Nuclear Regulatory Commission this year.
Given that markets are still unsure of how much lower the Fed’s policy rate could drop from here, Villere stated that his team “would rather play a bit more defense than offense” in small-cap stocks. Within the small-cap universe, he suggests defensive industries like healthcare, pharmaceuticals, and consumer staples.
In a phone interview with MarketWatch, Villere stated, “We’ve already had the first 25 basis point cut and are likely to get another one or two in 2025, but rates really have to come down much lower for cyclical sectors to work.”
It is not good for small caps when house builders are weak.
Indeed, a lot of investors doubt the small-cap rally’s viability, thinking it might be a head trick that ends quickly.
One way to look at it, according to Lori Calvasina, head of U.S. equities strategy at RBC Capital Markets, is to compare the performance of small-cap and home-builder companies, as they have, up until recently, been performing similarly to wider indices.
It’s interesting to note that home-building performance peaked in early September in comparison to the whole market before starting to decline. However, as small companies have continued to thrive, the Russell 2000/S&P 500 ratio has continued to rise,” a group of RBC analysts wrote in a client note earlier this week.
“Cautious” has been the attitude of a different RBC team that focuses on home builders, who believe that “the stocks have run too far, too fast, valuations are stretched, and interest-rate optimism has been overdone.” The analysts also pointed out that the long end of the curve is not declining sufficiently to ease the problem of housing affordability, which is still quite stretched.
Because the Russell 2000 is more heavily weighted in rate-sensitive regions, Bob Savage, head of markets macro strategy at Bank of New York Mellon, expressed concern that “we are not out of the woods yet.”
Markets will probably remain in “wait-and-see mode” ahead of the September jobs report, the possible government shutdown next week, and the beginning of the third-quarter earnings season in mid-October, Savage told MarketWatch.
The S&P 500 SPX was down 0.3% for the week, the Dow Jones Industrial Average DJIA was down almost 0.2%, and the Nasdaq Composite COMP was down almost 0.7% as U.S. stocks recorded weekly losses on Friday. FactSet statistics showed that the small-cap Russell 2000 was down 0.6% for the week.
