Small-cap stocks in the U.S. have experienced a surge in volatility after a lackluster 2023, raising questions about the implications for this long-struggling segment. The Russell 2000 index, which measures the performance of small and midsized companies, has seen seven consecutive sessions with significant moves in either direction, the longest streak since March 2023.
Despite this volatility, the Russell 2000 has outperformed the tech-heavy Nasdaq Composite, which fell 1.3% during the same period. The S&P 500 and Dow Jones Industrial Average also experienced declines, breaking their five-week winning streaks.
The volatility in small-cap stocks is closely tied to interest rates. When there is market sentiment that rates will stay high for an extended period, small caps tend to be punished. Conversely, when there are signals that the central bank’s monetary-tightening cycle may be coming to an end, small caps tend to recover.
The recent volatility was triggered by uncertainty surrounding the Federal Reserve’s decision to cut interest rates. A hotter-than-expected January inflation report led to a steep selloff across U.S. stock and government-debt markets, causing the Russell 2000 to decline by nearly 4%, its worst day since June 2022. However, dovish comments from Chicago Fed President Austan Goolsbee and a weak retail-sales report provided some relief to investors in the following trading days.
Small-cap stocks have been struggling to catch up to their large-cap peers. While the S&P 500 and Nasdaq have seen significant gains this year, the Russell 2000 has only risen by 0.3%. David Lefkowitz, head of equities for the Americas at UBS Global Wealth Management, believes that small caps are close to playing catch-up and expects them to outperform in the months ahead.
However, the recent rise in interest rates has not yet led to small-cap outperformance because earnings growth has not convincingly improved. A resilient U.S. economy is typically needed to support small-cap companies’ outperformance, and the volatility in the Russell 2000 suggests that investors are unsure about the economy’s trajectory.
The recent surge in volatility in small-cap stocks should be seen as an opportunistic rotation rather than a fundamental move. As the megacap-tech-led rally broadens out, investors are flowing into lagging sectors, including small caps. However, this rotation may only be profitable for those who successfully catch the waves. Unless there are signs of a strengthening economy or easing credit conditions, the Russell 2000 is likely to face headwinds that its larger peers will not.
In conclusion, the recent surge in volatility of small-cap stocks raises questions about the implications for this long-struggling segment. While the Russell 2000 has outperformed other major indexes, it is still struggling to catch up to its large-cap peers. The volatility is closely tied to interest rates, and investors are closely watching the Federal Reserve’s decision on rate cuts. Unless there are signs of a strengthening economy or easing credit conditions, small-cap stocks are likely to face challenges in the months ahead.
