Latest / Bull Market Conversations with Fexingo: Rallies, Momentum, and Riding Market Strength / Small Caps Are Leading This Rally and Heres Why
Transcript
- Lucas: So the Russell 2000 is up nearly 2 percent over the past five days, while the S&P 500 has barely budged — 0.5 percent. That is a real divergence, and it's happening against a pretty stable macro backdrop. Luna: Right — the Fed funds rate is sitting at 3.62 percent, GDP growth just ticked up to 2 percent annualised. So what's suddenly giving small caps the edge? Lucas: I think the key is that small caps are much more sensitive to domestic economic conditions and to interest rates. They don't have the same global revenue diversification that big multinationals do. So when the macro picture stabilises — and especially when rates stop going up — these stocks can react more dramatically. Luna: And we're in that sweet spot now: rates have been flat for weeks, GDP is positive but not overheating. The Fed seems comfortable. Lucas: Exactly. The effective Fed funds rate has been stuck at 3.64 since April. The daily rate is 3.62 as of yesterday. That is a clear signal the tightening cycle is done, even if cuts aren't imminent. For small caps that have been hammered by high financing costs, that's a green light. Luna: Worth noting too that the Ark Innovation ETF — ticker A-R-K-K — is up 2.3 percent over the same period. That fund is essentially a basket of high-growth, often unprofitable small and mid caps. So risk appetite is clearly coming back. Lucas: Yeah, that's a good point. Ark is up more than the Russell itself, which tells you the rally is concentrated in the more speculative names. But the Russell is broader — 2,000 companies — so a 1.8 percent move is meaningful breadth. Luna: Let's talk about why small caps underperformed for so long. The narrative has been that they're more leveraged, more exposed to rising rates, and less able to pass on costs. Lucas: Right, and that narrative played out brutally. From the start of 2022 through late 2023, the Russell 2000 lagged the S&P by something like 20 percentage points. But now rates are flat, inflation is cooling, and the domestic economy is actually growing at a decent clip. So the very things that hurt them are reversing. Luna: And there's a valuation angle too. Small caps have been trading at a discount to large caps on a price to earnings basis. That's not new, but when the environment shifts, that discount can close quickly. Lucas: It's one of those situations where the market is starting to price in a soft landing — or at least no recession. And for small caps, a soft landing is a much bigger relative boost than it is for the mega caps that have been riding AI enthusiasm. Luna: Speaking of AI — Cloudflare, CrowdStrike, Datadog — those are all up huge this week. But they're not really small caps anymore. Lucas: No, they're mid or large now. But the rotation I'm watching is into the real small-cap value and small-cap growth names that have been neglected. Banks, regional lenders, industrial suppliers, healthcare services — those are the sectors that tend to lead when small caps catch a bid. Luna: And a lot of those are rate-sensitive. Regional banks especially. They borrow short, lend long, so a flat yield curve has been brutal. But if the curve starts to steepen — if long-term rates stay elevated while short rates stay put — that's actually a tailwind. Lucas: Exactly. And we saw some of that this week. The ten-year Treasury has been hovering around 4.3, while the two-year is around 4.0. That spread is still inverted, but less so than it was a year ago. Luna: So the question is: does this small-cap rally have legs? Or is it just a catch-up trade after a few months of large-cap dominance? Lucas: I think it has legs, but not without bumps. Historically, small-cap leadership tends to last 12 to 18 months once it starts. But we're only a few weeks into this rotation. The risk is that if the economy softens — if GDP dips back toward 1 percent — small caps will get hit harder because they're more cyclical. Luna: And there's also the liquidity factor. Small caps are less liquid, so when institutions rotate in, the moves can be violent — both up and down. Lucas: Right. Today's environment — stable rates, moderate growth, no recession — is basically the sweet spot for small caps. But if we get a shock, they'll fall faster than the S&P. So it's not a risk-free trade. Luna: What about the index itself? The Russell 2000 is at 2,843. That's still below its all-time high from late 2021. So there's room to run. Lucas: Yeah, it's about 10 percent off its peak. The S&P, by contrast, is at 7,446 — that's a new all-time high. So small caps are playing catch-up. And that's exactly the kind of gap that tends to close during a broadening bull market. Luna: One thing I've been watching is the Ark fund — it's up 2.3 percent this week, but it's still down something like 60 percent from its peak. So the speculative froth isn't back to 2021 levels by any means. Lucas: And that's probably healthy. The rally we're seeing now is more fundamentals-driven than the 2020-2021 mania. Companies have had time to restructure, cut costs, and improve margins. The ones that survived the rate shock are in better shape. Luna: So for listeners who want to participate — how? Just buy the Russell 2000 ETF, or is there a more targeted approach? Lucas: The broad ETF — ticker i w m — is the simplest way. But if you want to be more strategic, you could overweight small-cap value, which tends to do even better in a rate stabilization scenario. The iShares S&P Small-Cap 600 Value ETF, for example, has a lower P/E and more exposure to financials and industrials. Luna: And avoid the ones that are still overleveraged or unprofitable unless you have a high risk tolerance. Lucas: Exactly. The Ark fund is up this week, but it's still a gamble. The broader small-cap rally is more sustainable because it's driven by companies that actually generate cash. Luna: Let's touch on one more data point: the Dow is up 1.5 percent over five days, the NYSE composite up 1.4 percent. So this isn't just a small-cap story — it's a broad market strength story. But small caps are leading. Lucas: Right. And that's the hallmark of a healthy bull market: breadth. When only the mega caps are rising, it's fragile. When the Russell, the Dow, the NYSE, and the S&P all move up together — even at different speeds — that's a sign of genuine demand for equities. Luna: So what's the one thing you'd tell a listener to watch over the next month to gauge whether this rotation continues? Lucas: Watch the yield curve. If the two-year Treasury yield starts to fall — meaning the market expects a rate cut — small caps could rally even more. But if the curve steepens because long-term yields rise — that's a different signal, possibly inflation concerns. I'd also keep an eye on the Russell 2000 relative to the S&P 500. If that ratio starts trending up, the rotation is real. Luna: And if it fails — if small caps start lagging again — then we're back to the narrow market. But for now, the data says small caps are having their moment. Lucas: Absolutely. It's been a long time coming. And it's worth paying attention to because it changes how you think about portfolio construction. Small caps aren't just a satellite holding anymore — they might be the core opportunity. Luna: Alright, great conversation. Let's see if this holds into June. Lucas: We'll be watching.