What’s driving the rotation into small-cap stocks?

Volatility is back in equity markets: 

• There was a decline in meg-cap tech stocks last week and small caps fell nearly 2% in their worst day since April on Thursday.
• The VIX is at the highest level since April.

Markets are feeling like a…market. 

The S&P 500 saw one of its worst weeks since mid-April and the NASDAQ 100 recorded its first negative week since mid-May. All the while, small caps are up more than 7% this month – outpacing both the S&P 500 and NASDAQ 100.

Yields were higher across the curve, but markets are still pricing a 95% chance of a September cut. 

As markets digest the speed of the equity rotation, we offer our interpretation below.

Small caps are shining

Through the first half of this year, large caps carried the market. The S&P 500 and NASDAQ 100 outperformed small caps (Solactive 2000) by more than 16% and 18%, respectively. Since the midpoint, however, the tables have turned. Small caps have rallied over 9% compared to just over 2% for the S&P 500, and less than 1% for the NASDAQ 100.

The returns in the first half of the year were top-heavy: Just four stocks (Nvidia, Microsoft, Alphabet and Amazon) contributed more than half of the S&P 500’s gain, while nearly 40% of the index was negative. In the second half of the year, only 20% of the index so far has a negative return, including all four companies listed above.

Performance is broadening across the equity market. As we argued before, we think this can continue. 

Three reasons this is happening now

1) The fundamentals. We are moving into a “Goldilocks” scenario for the Federal Reserve. Inflation is coming down, and growth is moderating but not stalling. The inflation data continues to give us more confidence that inflation is no longer threatening. This month’s CPI report showed the first month-over-month decrease since 2020, and Bank of America’s Institutional Fund Manager survey showed that higher inflation is no longer investors’ number-one tail risk.

The consumer is still strong. Retail sales in the all-important control group for the month of June were more than four times Street expectations, and the Atlanta Fed’s GDPNow forecast is for the economy to grow 2.7% in the second quarter. At the same time, according to the Bank of America survey, almost 40% of investors think monetary policy is too restrictive—the highest since 2008. This backdrop of decent growth with fading inflation pressures and room to cut rates is compelling for risk assets. 

That’s the macro setup. On the micro, nearly 40% of the Solactive 2000 (small caps) are unprofitable, and that means they are more dependent on capital markets for financing than large caps, which can fund operations through cash flow. Thus, lower rates have an outsized impact on small caps relative to large caps. 

2) The technicals. Given the smaller size and relatively less liquidity of the small-cap market, technicals also play a bigger role. Hedge funds came into the month with a near-record short position in small caps. When positioning is that stretched, it only takes a small spark to ignite a powerful rotation.

It wasn’t just short covering. For the week ending July 12, equity ETF’s had their second-highest flows of 2024. Most of the dollars on a nominal basis went to large-cap ETFs. But relative to size, small caps were the big winner. The iShares Russell 2000 ETF recorded an inflow of $3.7 billion, which is more than 6% of its market cap, compared to the 2.4% market cap inflow for the SPDR S&P 500. 

3) The political landscape. Per PredictIt, there is a 63% chance that a Republican will win the presidential election, up eight percentage points from just a month ago. As we noted in our Mid-Year Outlook, small-cap equities would likely benefit from the prospect of lower taxes and less onerous regulations. For only the second time in the index’s history, the Solactive 2000 rallied to a new 52-week high after a five-day 10% rally. The only other instance? November 11, 2016, the business day after national election polls closed and Donald Trump became President-Elect. The index rallied a further 7% over the next month and was 14% higher a year later.

What to do?

Assess portfolio positioning and consider an allocation to SMID cap stocks. We think outperformance in the style factor can continue, as several of the tailwinds we mentioned have long runways. For those portfolios where an allocation make sense, we think the best way to access the factor is through active management. Skilled managers can find quality companies in the space, producing cash flows that trade at a discount. 

As always, your J.P. Morgan team is here to help.

All market and economic data as of July 2024 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.

We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice.

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• Past performance is not indicative of future results. You may not invest directly in an index.
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• Opinions expressed herein may differ from the opinions expressed by other areas of J.P. Morgan. This material should not be regarded as investment research or a J.P. Morgan investment research report.

Index definition

S&P 500: The Standard and Poor's 500, or simply the S&P 500, is a stock market index tracking the stock performance of 500 of the largest companies listed on stock exchanges in the United States.

NASDAQ 100: The NASDAQ-100 is a stock market index made up of equity securities issued by 100 of the largest non-financial companies listed on the Nasdaq stock exchange. It is a modified capitalization-weighted index.

Solactive United States 20000 Index (Solactive 2000): The Solactive United States 2000 Index intends to track the performance of the largest 1001 to 3000 companies from the United States stock market.