Small caps beating the S&P 500 MTD in August. Will the outperformance continue?

The Russell 2000, which tracks U.S. small-cap stocks, has outperformed the large-cap S&P 500 by nearly twofold since the start of August. RBC Capital Markets expects the trend to fade soon, while Morningstar takes the opposite view, arguing that small caps remain relatively cheap.

The Russell 2000, a benchmark for U.S. small- and mid-cap stocks, rose 5.0% between August 1 and August 19. Over the same period, the large-cap S&P 500 added 2.7%.

Last week, the Russell 2000 index gained 3.2% versus a 1.2% gain for the S&P 500. The outperformance "had more to do with a ramping up of Fed cut expectations” than the outlook for earnings for small-cap stocks, argues Lori Calvasina, head of U.S. equity strategy research at RBC Capital Markets, in a note quoted by MarketWatch.

Traders’ expectations for a rate cut increased after the U.S., on August 12, released inflation data showing consumer prices rose 2.7% year over year in July, just below the 2.8% consensus estimate. The Fed is now projected to make three quarter percentage point cuts this year, up from two, according to the CME FedWatch Tool, CNBC wrote. Weaker-than-expected U.S. inflation suggests it may be time to pivot into small-cap stocks and other risk assets, Morgan Stanley said it a recent note. It would benefit smaller companies, whose borrowing costs are often floating.

Calvasina of RBC Capital Markets thinks the recent outperformance in small-cap stocks will probably run out of steam. For sustainable outperformance, small-cap stocks “tend to need an outright recession or a very hot economy,” she said. Such conditions “are lacking at the moment."

RBC is “neutral” on small-cap stocks over the next 6-12 months, partly because of “elevated valuations” and expectations for U.S. GDP to expand at a slower pace, according to the note. As of mid-August, RBC expected U.S. GDP growth would slow to 1.6% in 2025 and to 1.3% in 2026. Last year, real GDP increased 2.8%, the note said.

Should expectations for Fed rate cuts continue to grow, the near-term outlook for earnings and “deep net short positions” may help keep the small-cap trade going, Calvasina reckons. The P/E ratio for the Russell 2000 is already above average at 16.3.

Morningstar, for its part, considers small caps as still relative cheap. It estimates the asset class is trading at a 16% discount relative to its fair value. However, small caps may “take a while before they work,” since they tend to outperform during a recovery from an economic downturn, Morningstar's chief U.S. strategist, Dave Sekera, wrote in an August stock market outlook report.

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