U.S. small-cap stocks have enjoyed an epic rally over the past month since the Federal Reserve signaled that its first rate cut of the year could be imminent — but investors remain concerned about whether gains in one of the market’s most battered corners can be sustained amid uncertainty about the outlook for the economy and monetary policy.

The Russell 2000 has risen 3% over the past month, while the large-cap benchmark S&P 500 has risen just 1.4% over the same period, according to FactSet.

Small-cap stocks have been volatile since the Fed's signal. The Russell 2000 surged about 13% in July, its best month in nearly two years, but gave up almost half of those gains in August. Now, market analysts think the bullish momentum could continue.

Equity market participants are generally optimistic that small-cap stocks will continue to outperform the broader market in the coming months -- largely due to expectations that the Federal Reserve will begin cutting interest rates on Wednesday and the potential for a so-called soft landing for the U.S. economy.

Small-cap stocks are often more sensitive to changes in borrowing costs and economic conditions because smaller companies tend to have higher debt levels than larger companies and rely more on external financing to operate.

Valuations also appear to favor small-cap stocks, with earnings expectations for smaller companies expected to grow faster than those for larger companies. As of Sept. 16, the S&P Small Cap 600 had an estimated 12-month price-to-earnings ratio of 16.7, compared with an estimated 23.4 for the S&P 500. Small-cap index members are expected to see earnings growth of about 20% through 2025, compared with about 15% for the large-cap benchmark, according to FactSet data.

“The Fed’s rate cuts starting this week are likely to be a catalyst for investors to focus on small-cap companies given their valuation discounts, underlying earnings growth and the cyclical nature of small-cap stocks,” said Matt Palazzolo, senior investment analyst at Bernstein Private Wealth Management.

While investors widely expect the Federal Reserve to begin easing monetary policy this week, the extent of its rate cuts remains uncertain.

As of Monday, traders in the fed funds futures market saw a 63% chance of a 50 basis point rate cut by the Fed later this week, up from about 40% on Friday, according to CME Group’s FedWatch tool. They saw a 37% chance of a 25 basis point cut.

Jonathan Krinsky, chief market technician at BTIG, said a large 50 basis point rate cut could further support small-cap investing. But there are concerns that a bigger rate cut could raise alarms that the U.S. economy is slowing more than expected, which could hurt corporate earnings and broader financial markets.

“The economic situation is the final piece of the puzzle, and the way for investors to really get on board the small-cap train is to see above-trend earnings growth for the group, and that hasn’t materialized yet,” said Jordan Irving, portfolio manager at Glenmede Investment Management.

However, Palazzolo said small-cap investors shouldn’t get hung up on the debate over 25 basis points or 50 basis points because such a magnitude “would not have that much of a long-term impact on the economy.”

“Whether policymakers cut rates by 25 basis points first or 50 basis points first this week — that will certainly have an impact on stock market performance in the short term, but it won’t have an impact on the difference between small-cap stocks and large-cap stocks over a meaningful period of time,” he said.

Jay Hatfield, CEO of Infrastructure Capital Advisors and portfolio manager of the InfraCap Small CapIncome ETF, said the recent outperformance of small-cap stocks looks like part of a "value versus growth" story that emerged when the so-called "Magnificent Seven" group of large-cap technology stocks hit resistance earlier in the summer.

He noted that some small-cap indexes are highly skewed toward interest-rate sensitive and dividend-paying sectors, such as financials and real estate.

The S&P Small Cap 600's financial sector has been the second-best performer among the index's 11 sectors over the past three months, rising 21.6%, while the index's real estate sector has risen 18.1% over the same period.

Financials and real estate were also among the best performers in the S&P 500 during the same period, FactSet data shows.

Article forwarded from: Jinshi Data