The Russell 2000 index, a key indicator for small-cap stocks, has recently surged to unprecedented levels, surpassing the S&P 500's performance since April of this year. This upward trajectory is largely fueled by market anticipation of impending interest rate reductions, which typically bolster smaller companies. However, beneath this impressive headline performance, a nuanced picture emerges, with some investors flagging potential concerns. A significant portion of the index's gains has been concentrated in unprofitable companies, leading to a disparity in performance compared to their profitable peers. Nevertheless, many fund managers retain a positive outlook on small-caps, emphasizing their current attractive valuations and the expectation of robust earnings growth in the near future.
A closer examination of the Russell 2000 reveals a notable divergence in the performance of companies based on their profitability. As of October 21st, unprofitable companies within the index had experienced a substantial increase of approximately 19% this year. This growth rate is more than double the 9% gain observed in profitable firms, according to Oren Shiran, a portfolio manager at Lazard US Systematic Small Cap Equity ETF. This trend raises questions about the sustainability of the current rally and whether it is being driven by speculative fervor rather than fundamental strength. The S&P 600, another small-cap index that specifically includes companies with positive earnings, has seen a more modest increase of about 2% for the year, lagging behind the returns offered by low-risk certificates of deposit.
Shiran attributes this speculative uptick to investor excitement surrounding potential interest rate cuts. Lower interest rates generally create a more favorable environment for smaller companies, as they often rely more heavily on borrowing for growth and expansion. Despite Federal Reserve Chair Jerome Powell's recent efforts to moderate expectations regarding future rate cuts, market participants largely anticipate further reductions. This anticipation continues to fuel optimism for small-cap performance, with many believing the sector is poised for continued growth.
Despite the observed speculative tendencies, fund managers remain largely bullish on small-cap stocks. Their confidence stems from several factors, including the expectation of significant earnings growth following a two-year period of relatively stagnant profits. Furthermore, small-cap valuations were considered attractive at the end of the third quarter, even after their rally from April lows. This is supported by data from Royce Investment Partners, which indicates that the Russell 2000's total market capitalization as a percentage of the broader Russell 3000 index stands at 4.4%, considerably below its historical average of 7.6% since late 1984. Additionally, when comparing small-cap valuations to large-caps using enterprise value to earnings before interest and taxes (excluding unprofitable companies), small-caps are currently near 25-year lows. Analyst projections further bolster this optimism, with the Russell 2000's estimated earnings for 2025 expected to climb over 25%, significantly outpacing the Russell 1000's projected 10% increase.
A robust domestic economy is typically seen as particularly advantageous for smaller companies, given their generally lower exposure to international markets. While recent economic indicators, such as employment figures and consumer confidence, have shown some volatility, overall consumer spending remains strong, and the economy continues to expand. The widening access to capital, partly due to the reduction in interest rates, further supports the growth prospects for small businesses. While concerns persist about overall stock market valuations, with major indexes at record highs, small-caps have not experienced the same prolonged period in the spotlight as their larger counterparts. Should market dynamics revert to long-term averages, as suggested by the theory of mean reversion, small-cap stocks are well-positioned for sustained growth.