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Dow Jones NewsAug 19, 8:37 PM UTC
MW Why small-cap stocks may be running out of 'runway' after recent outperformance
By Christine Idzelis
The Russell 2000, a gauge of U.S. small-cap stocks, is beating the S&P 500 so far in August
There may not be much runway left for small-cap stocks after their recent pop relative to large-cap equities, RBC Capital Markets cautions.
The recent outperformance in small-cap stocks will probably run out of steam after rallying on increased optimism that the Federal Reserve will lower interest rates over the next year, according to RBC Capital Markets.
The Russell 2000 index RUT, a measure of small-cap stocks in the U.S., has risen 2.9% so far in August through Tuesday, according to FactSet data. That easily exceeds the 1.1% gain this month for the S&P 500 SPX, a benchmark for U.S. large-cap equities.
For sustainable outperformance, small-cap stocks "tend to need an outright recession or a very hot economy," said Lori Calvasina, head of U.S. equity strategy research at RBC Capital Markets, in a note emailed Tuesday. Such conditions "are lacking at the moment," she said.
RBC is "neutral" on small-cap stocks over the next six to 12 months, partly because of "elevated valuations" and expectations for U.S. gross domestic product to expand at a slower pace, according to the note. Calvasina found that the Russell 2000's recent rally took the ratio of small-cap to large-cap performance to the "high end of its post-Liberation Day range" around the middle of last week.
The Russell 2000's outperformance last week "had more to do with a ramping up of Fed cut expectations" than the outlook for earnings for small-cap stocks, she said. Should expectations for Fed rate cuts continue to grow, the near-term outlook for earnings and "deep net short positions" may help keep small-cap trading going, according to her note.
"But our valuation work suggests that there may not be too much runway here as the Russell 2000 P/E is already above average at 16.3x," Calvasina wrote, referring to the price-to-earnings ratio for the U.S. small-cap stock index.
Small caps have broadly trailed so far in 2025, with the Russell 2000's 2.1% rise year to date lagging the S&P 500's 9% gain, FactSet data show.
"Some stabilization has emerged after the tariff tantrum when financial market participants began to price in cuts again," said Calvasina. While the weak July jobs report, released earlier this month, "caused Fed cut bets to ramp up again," it wasn't until last week's inflation reports for July that small caps saw "a noteworthy lift" relative to large caps, according to her note.
Investors are expecting the Fed to cut rates this year, potentially as soon as next month.
Traders in the federal-funds-futures market saw on Tuesday an 84.8% probability that the Fed will lower its benchmark rate by a quarter percentage point at its next policy meeting in September, according to the CME FedWatch Tool, at last check. They were anticipating that the Fed, which currently maintains its policy rate at a range of 4.25% to 4.5%, will cut rates two or three times by yearend.
Meanwhile, central bankers will gather in Wyoming this week for the annual Jackson Hole Economic Policy Symposium, with Fed Chair Jerome Powell's speech scheduled for Friday.
Read: Will Powell use Jackson Hole speech to push back on hopes for September rate cut?
Deep rate cuts and lengthy recessions are typically "springboards" for leadership in small caps, according to the RBC note. But quick recessions, as seen in 2020, or cutting cycles that are short and shallow, as they were in 1995 and 1998, have tended to result in small-caps seeing a "brief leadership trade" without "a major pivot towards outperformance," the chart below shows.
RBC CAPITAL MARKETS
As of mid-August, RBC expected U.S. GDP growth would slow to 1.6% in 2025 and to 1.3% in 2026, the note shows. Last year, real GDP increased 2.8%, according to Calvasina's note.
The U.S. stock market closed mostly lower Tuesday, with the S&P 500 falling 0.6%, the technology-heavy Nasdaq Composite COMP dropping a sharp 1.5% and the Dow Jones Industrial Average DJIA eking out a gain of less than 0.1% to finish nearly flat. The Russell 2000 index declined 0.8%.
-Christine Idzelis
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08-19-25 1637ET
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