Small caps outpacing the S&P 500 in July: What's driving the rally and will it last?

In July, investor attention shifted away from tech giants and AI toward small-cap stocks that had long lingered in the shadow of Big Tech. Since the start of July, the Russell 2000 index has climbed 3.8%. By comparison, the S&P 500 has gained 3.0%, the Nasdaq Composite 4.0%, and the Dow Jones Industrial Average 1.7%, according to FactSet data. The outperformance suggests a broader market rotation is underway: from high-valuation tech names to more economically sensitive sectors.

The shift has been supported by growing risk appetite and solidifying expectations that capital may flow out of AI companies and into undervalued parts of the market. Political factors have also buoyed sentiment around small caps, as investors anticipate that the Trump administration will mean tax breaks and less red tape for smaller firms, along with a push to reshore production.

Investor optimism may be premature: "Larger-cap stocks are just able to better absorb the cost increases and the adverse effects of tariffs, given their stronger quality and profitability," Nanette Abuhoff Jacobson, a global investment strategist at Hartford Funds, told MarketWatch. "Beware of calling a small-cap rally, because they tend to be quite fleeting." 

The imposition of tariffs has fueled concerns over rising inflation and heightened recession risks. This has limited the Fed’s ability to continue cutting rates, adding pressure to smaller companies, which tend to be more rate-sensitive.

Still, markets are pricing in further easing. Nearly half of interest rate traders expect the Fed to deliver two 25-basis-point cuts before the end of 2025, to bring the fed funds rate to a range of 3.75-4.00%, according to the CME FedWatch Tool. "One or two cuts is not going to make a huge difference, as we’re still operating in a relatively high-interest-rate environment compared to previous years," said Jacobson of Hartford Funds.

At the same time, valuations have crept higher. In June, the P/E ratio increased across most segments of the small-cap market. The Russell 2000’s P/E rose from 14.9 to 15.5, about 3% above historical averages, BofA stated in a July 14 report. That said, the relative P/E of small caps versus large caps remains at a subdued 0.71, roughly 30% cheaper than the long-term average.

Valuations suggest the Russell 2000 could deliver higher annualized returns over the next 10 years, at around 9%, versus 5% for companies in the Russell Midcap and just 1% for the Russell 1000, according to BofA.

While the technicals paint a bullish trend for small caps, the underlying fundamentals tell a "less convincing story," raising questions about the sustainability of the current small-cap rally, notes MarketWatch.  

BofA believes second-quarter earnings may show signs of a recovery in small-caps' EPS, but admits it could be delayed. The Wall Street consensus forecast has shifted to now expect a small-cap earnings recovery in the second half of the year. However, the forecast of 25% EPS growth in the fourth quarter looks too optimistic given the slowdown in U.S. GDP, weaker-than-expected recovery in the manufacturing sector, risks associated with tariffs, and the BofA baseline scenario that the Fed will not cut rates until the end of the year, analysts point out.

The small-cap financial sector leads the pack, posting the strongest performance across all four key metrics: attractive valuations, solid upward revisions to earnings forecasts, sustained price momentum, and improving analyst sentiment, according to BofA. The bank also highlights several potential growth drivers for regional banks, including stable profit margins, accelerating loan growth, and a pickup in M&A activity.

At the other end of the spectrum, health care is the worst rated small-cap sectors, followed by energy. Within the mid-cap space, Consumer Discretionary and Industrials rank as the least attractive segments.

BofA stresses that when investing in small-cap stocks, it is crucial to consider index composition. Comparing two widely used benchmarks, the S&P SmallCap 600 and the Russell 2000, it points to a key distinction: Roughly 35% of the companies in the Russell 2000 are unprofitable, skewing the index’s overall performance.

When loss-making firms are excluded and the forward P/E is calculated based solely on profitable companies, the valuation comes in below the long-term average for the S&P SmallCap 600. That implies a meaningful discount that may appeal to fundamentals-driven, value-oriented investors. On a headline basis, however, the Russell 2000 appears rich relative to the S&P SmallCap 600 due to the drag from unprofitable constituents, BofA concludes.

Since the start of 2023, the Russell 2000 has risen 28.4%, outpacing the S&P SmallCap 600’s 19.0% gain over the same period. Much of that divergence, again, stems from differences in index composition: The Russell 2000 has a larger weighting of IT stocks, which have powered growth, showing stronger returns.

Select high-growth names have also helped lift the index. One standout is Super Micro Computer, whose shares have nearly doubled year to date. The stock is included in the Russell 2000 but is not part of the S&P SmallCap 600.

Historically, dating back to 1994, gaps in performance between the S&P SmallCap 600 and the Russell 2000 have been closely tied to macroeconomic conditions as well. The former tends to outperform during periods of rising inflation, as increases in consumer prices disproportionately impact the more fragile, cost-sensitive companies that populate the Russell 2000.

Conversely, an uptick in business activity, as reflected in ISM PMIs, has historically favored the Russell 2000, given its greater sensitivity to economic momentum.

Should business activity continue to slow while inflation proves more persistent than expected, the backdrop would likely tilt in favor of the S&P SmallCap 600 over the Russell 2000, BofA concludes.

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