'Structurally inferior': Some strategists cautious on small caps after record highs

In the fourth quarter, small-cap stocks are unlikely to perform as strongly as they did in the third, when the Russell 2000 cleared its prior record going back to 2021, according to Adam Parker, founder of Trivector Research. He called small caps a “structurally inferior asset class,” pointing to their weaker profitability and overall quality. Citi strategist Chris Montagu also warned that increasing bullish bets have left markets more fragile, especially if momentum stalls.

The growth that small-cap companies showed in the third quarter is unlikely to continue in the next three months, according to Adam Parker, founder of Trivector Research. His opinion was quoted by CNBC.

The impressive performance of small caps in the third quarter is unlikely to persist in the months ahead, CNBC quoted Parker as saying. He attributed this to what he described as the “structural inferiority” of the asset class, given that “there is more junk than quality” among small-cap names, and that these companies tend to be less profitable and more cyclical than larger peers.

Still, Parker noted that the opportunity to achieve alpha – excess returns relative to the market – is stronger among small-cap stocks than in the S&P 500, given their higher company-specific risk.

Despite his cautious outlook, Parker said some individual small caps could continue to perform well in the fourth quarter, though investors will need to be selective. CNBC cited three companies he views as promising.

Even so, Parker advised against owning more small caps than S&P 500 stocks “in absolute terms... and [we] would advise heavily against that.” 

The small-cap rally gained momentum in August as investors positioned for easing by the Fed. At the September 16-17 FOMC meeting, the central bank cut its benchmark rate by 25 basis points to 4.00-4.25%. The move ignited another leg higher for smaller stocks: on September 18, the Russell 2000 surged 2.5% to an all-time high of 2,467.7 points, surpassing its previous peak set in November 2021.

The rally carried into October, with the index crossing the 2,500-point threshold for the first time on October 6. However, the momentum quickly faded, and by the close yesterday, October 8, the Russell 2000 had retreated to around 2,484 points.

Citi strategist Chris Montagu noted that the Russell 2000 saw the sharpest rise in bullish positioning among major indexes during the week of September 29 to October 3. In a client note cited by Yahoo Finance, he warned that this strong buying activity has left markets “more fragile,” particularly if momentum stalls.

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