Russell 2000 nears record high: How long can the small-cap rally last?

The Russell 2000 index, which tracks small- and mid-cap stocks, has risen 5% over the last month and could soon surpass its 2021 record. Some Wall Street strategists believe the rally is just beginning, while others argue these companies may struggle to sustain momentum amid a sluggish economy.

The Russell 2000 has added 5% over the last month, more than double the gain of the S&P 500, which reflects the performance of the largest U.S. stocks. The S&P 500 advanced 2.15% over the same period.

The Russell 2000 closed on Friday, September 12, just above the 2,397-point mark, just 45 points off of the record high reached on November 8, 2021, writes Barron's. Investors see the potential for more gains, its says, partly because of monetary policy.

Wall Street analysts surveyed by Barron's and Bloomberg believe in the small-cap rally, but their views differ on how long it will last.

The small-cap market has been on a tear, and a spate of Wall Street strategists say the rally is just getting started, Bloomberg writes. A bottom-up aggregation of price targets shows analysts see the potential for a 20% advance in the Russell 2000 over the next year, versus calls for an 11% jump in the S&P 500, according to data compiled by Bloomberg. This would flip the trend of this year: to date, the Russell 2000 has added 7.6%, while the S&P 500 has gained 17.7%.  

Wall Street expects this week's expected Fed cut to reduce borrowing costs for Russell 2000 companies enough to lead to significant margin expansion. Morgan Stanley’s Michael Wilson said in a research note that Fed cuts could spur the “next leg” of the bull market and lift small cap stocks. He upgraded small caps to "neutral" from "underweight" earlier this month but said he still needs to see a jump in the group’s earnings revisions breadth before going "all in."

In the second quarter, more than 60% of Russell 2000 companies beat Wall Street earnings forecasts, the agency points out. The combined profits of all index participants will grow on average by more than 50% over the next four quarters, this is almost five times the estimated rate of profit growth of issuers from the S&P 500 index, Barron's cites the forecast of London Stock Exchange Group, a provider of data on financial markets.

Second-quarter earnings came in above estimates for more than 60% of stocks in the Russell 2000, data compiled by Bloomberg Intelligence show. Collective earnings from the benchmark’s 2,000 constituents, meanwhile, are forecast to grow by more than 50% on average over the next four quarters, nearly five times the pace of S&P 500 profits, based on LSEG estimates.

The combination of earnings growth, rate cuts, and low valuations is “a pretty good collection of things for mid- to small-caps rally,” Tom Hainlin, national investment strategist at U.S. Bank NA, told Bloomberg. The group has been “underappreciated” this year as “almost every equity class is trading a valuation premium to their 20-year averages” except for the U.S. mid-cap value stocks and small caps, according to Emily Roland and Matt Miskin, cochief investment strategists at Manulife John Hancock Investments.

Lori Calvasina, RBC Capital Markets’ chief U.S. equity strategist, noted that the small-cap rally needs “signs that the economic backdrop is exiting sluggish territory and turning hot,” she was quoted by Bloomberg as saying. "We think it will be difficult for small-caps to sustain any kind of major, durable outperformance trade as long as economic sluggishness remains the norm," Calvasina concludes.

Stock investors are worried about economic growth following a series of readings that suggest a notably weaker labor market heading into the final months of the year, Barron's writes. Adam Turnquist, chief technical strategist at LPL Financial, also cautions that a good portion of the Russell 2000’s recent gains could be paradoxically linked to bets against it. “The rally in small-caps has caught many off guard – and on the wrong side of the trade for many speculators in the hedge fund space,” he said, noting that data from the Commodity Futures Trading Commission shows the largest short positions held by hedge funds and other big players since 2022.

The AI translation of this story was reviewed by a human editor.