Excitement is brewing in the stock market as futures suggest that stocks are poised to rise and possibly hit new highs. But what has been catching attention recently is small-cap stocks.

When we talk about small-cap stocks, we refer to the stocks that represent companies with smaller market values, typically between $300 million and $2 billion, and compared to mid-cap (market capitalization between $2 billion and $10 billion) and large-cap stocks (market capitalization typically over $10 billion – usually well-established companies such as big tech companies), these stocks tend to be very volatile due to lower trading volumes.

Nevertheless, despite the higher volatility associated with small-cap stocks, they often tend to outperform when the economy is performing well. And since there is a strong possibility of rate cuts occurring soon, small-cap stocks are gaining more attention. This is primarily because small-cap stocks tend to be more sensitive to borrowing costs than larger-cap stocks due to the fact that smaller companies often have higher debt levels relative to their size, making their financing costs more impacted by rate fluctuations.

In addition, due to their limited access to capital markets compared to large corporations, small-cap companies rely more heavily on bank loans and other interest-rate-dependent sources of financing. Therefore, any reduction in interest rates by central banks like the Federal Reserve can lower the cost of capital for small-caps, and potentially enhance their profitability and growth prospects. 

Now, the question is: is this just a short-lived trend, or could it lead to longer-term growth? 

Well, one thing for sure is that there is significant optimism. Many believe that small-caps, as tracked by the iShares Russell 2000 ETF (IWM), do present a compelling investment opportunity. In fact, it has been stated that many experts believe that small-caps could gain 50% in 2024, especially since they are up only 6% so far this year.

Also, if we look at historical performance, we can see that it reinforces the positive outlook for a rally in small-cap stocks. For example, last year, when the Fed chose to pause rate hikes, small-cap stocks responded robustly as the IWM surged approximately 27% from October to December. Therefore, we could say that if the rate cuts do actually materialize, it is very likely that small-cap stocks will rise significantly too.

Moreover, there are two additional positive signs that are boosting small-cap stocks even further:

Firstly, regional banks, which comprise a large portion of the financial sector in the IWM, are gaining positive attention for their potential to thrive in a lower interest rate environment; and as these banks prosper, they can contribute to increased investor interest and potentially higher stock prices for small-cap companies. 

Secondly, there is a narrowing yield spread between higher-risk (CCC-rated) and lower-risk (BB-rated) debt of smaller companies. This is relevant because when the yield spread shrinks, it suggests that investors perceive smaller companies as less risky relative to higher-risk options. Therefore, investors are increasingly confident in the stability of small-cap stocks. 

Ultimately, there is indeed strong potential for a bullish trend in small-cap stocks. Nonetheless, as this trend is mostly dependent on the likelihood of rate cuts, the short answer to whether the trend is short-lived or long-lasting is that it is too early to tell definitively. 

Most of the latest economic data has shown that the U.S. economy is on a path to improvement, yet inflation, as revealed by the latest Producer Price Index (PPI), is still rising. Additionally, as stated by Fed Chair Jerome Powell, the Fed is carrying out a “wait-and-see” approach, thus, there is no absolute certainty that rate cuts will be implemented.

In conclusion, while the recent rise in small-cap stocks appears promising for potential investors, it is important to closely monitor forthcoming economic data releases. The next key reports to watch include the Gross Domestic Product (GDP) and the Personal Consumption Expenditure (PCE) index, scheduled for release next week.