By Jacob Sonenshine
Small-caps just had their best first six months in 35 years — and they should continue outperforming the S&P 500 in the days to come.
Yes, it was a messy — and volatile — week for markets. The S&P 500 advanced 1.8%, while the Dow Jones Industrial Average rose 2%, and the Nasdaq Composite gained 2.1%. The small-cap Russell 2000 finished the week off 0.4%.
But those weekly gains fail to capture the changes that have been happening underneath the hood. Despite the strength in the S&P and the Nasdaq, chip stocks tumbled, with the VanEck Semiconductor exchange-traded fund finishing the week off 3.2%. The losses came amid concerns that Meta Platforms' decision to sell cloud computing could be a sign of excess capacity.
Enter small-caps. While the Russell 2000 dipped for the week, it just finished the best first half of a year since 1991, gaining 22% to the S&P 500's 10%. To some observers, it's a sign that investors are open to areas beyond technology. "Portfolio managers [are] looking for other opportunities outside of owning AI," says Jason Ware, chief investment officer of Albion Financial Group.
Continuing to invest in small-caps might seem unwise, given that the Federal Reserve is more likely to raise rates than to cut them. Inflation, after all, is still well above the Fed's 2% target and shows little sign of getting there. Still, falling oil prices — WTI Crude oil has dropped from a peak above $110 a barrel to roughly $68, near its pre-Iran war level — combined with a job market that is growing, but not very quickly, could be enough to keep the Fed on hold despite a 46% chance of a hike at the September Federal Open Market Committee meeting.
Expectations for an interest-rate hike, meanwhile, have tended to be good news for small-cap stocks. They have gained 10%, on average, in the six months heading into a hike, while outperforming large-caps, according to Jefferies strategist Steven DeSanctis. That's in large part because the " economy is strong and accelerating, hence the reason to raise rates," he explains.
A strong economy is good news for small-cap earnings. DeSanctis expects Russell 2000 earnings to grow by 15.7% by the end of year, and close much of the gap with large-caps. While small-caps aren't cheap — the iShares Russell 2000 ETF sells for just over 26 times analysts' aggregate earnings forecasts for the coming 12 months, a 28% premium to the S&P 500's just over 20 times — that kind of earnings growth makes the valuation more palatable.
And then there's the Russell's outperformance itself. The index has outperformed the S&P 500 by 10 points or more during the first six months of the year just three times since 1987, and it continued to outperform over the following 12 months twice. Only in 1988 did small-caps turn into laggards.
We'll take those odds and just keep riding the small-cap wave.
Write to Jacob Sonenshine at jacob.sonenshine@barrons.com
This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.