Small-cap stocks are finally having their moment in the spotlight after years of lagging behind, but can the momentum last? New research from Bank of America outlines two specific indicators that, if triggered, could lead to continued gains for small-cap stocks.

According to the bank, the model currently shows that when the 10-year Treasury yield remains below 4% and the ISM Purchasing Managers Index (PMI) rises above 50, the equal-weighted S&P 500 (SPW) outperforms the market-cap-weighted S&P 500 (SPX), which is more exposed to large-cap technology stocks. The SPW is considered a good indicator of small-cap strength.

“Historically, when the model is triggered, SPW has outperformed SPX 90% of the time, by an average of 6.3 percentage points,” BofA analysts wrote.

The specific calculation method of the two signal points of the model is that the 10-year US Treasury yield falls by more than 1% from its 12-month peak and the ISM Purchasing Managers' Index PMI rises by more than 4 points from its low point.

Small-cap stocks gained momentum after unexpectedly benign inflation data for June, which boosted confidence that the Federal Reserve is on the verge of an imminent rate cut. Investors now see a 93.6% chance that the Fed will begin easing policy in September.

As a result, investors are increasingly keen to embrace sectors that are expected to benefit from lower borrowing costs. Such stocks, which are often sensitive to leverage, could see big gains in the coming months.

The Russell 2000 index, which focuses on small-cap stocks, had surged more than 12% in July before paring gains. For Bank of America, its recent highs marked its biggest move since March 2020.

High interest rates and frenetic trading in big tech stocks have limited the Russell 2000’s momentum for much of this year. But as investors begin to snap up shares of the overlooked index, some see it as evidence of a broad market rotation.

“I think August is going to be a time when the rotation becomes more pronounced, and I think small-cap stocks will outperform, while the S&P 500 is likely to be flat or slightly down,” Fundstrat’s Tom Lee said last week, predicting 40% upside for the Russell 2000.

However, there are skeptics. Barclays found that small-cap stocks don’t always outperform the S&P 500 after the Fed’s first rate cut. In fact, the Russell 2000 tends to fall after the Fed cuts rates, analysts said.

Currently, neither the 10-year Treasury yield nor the PMI data meet the two criteria proposed by Bank of America. Although the 10-year Treasury yield has gradually declined since it peaked in May, it is still above 4%. At the same time, the manufacturing PMI fell to 48.5 in June.

"The manufacturing economy is in the second-longest recession cycle in history, with no PMI above 50 for more than 2 months for 21 consecutive months," said analysts at Bank of America. "We believe much of this is driven by a destocking cycle, which we expect to ease in the second half of the year."

Article forwarded from: Jinshi Data