U.S. Economic Resilience Boosts Outlook for Small-Cap Stocks as Wall Street Expects a Rebound Opportunity

According to Zhihu Finance APP, despite the recent persistent pressure on U.S. small-cap stocks from surging U.S. Treasury yields and higher borrowing costs, the resilience of the U.S. economy is reinforcing the logic for a rebound. Bank of America points out that for small-cap stocks, which are highly dependent on the domestic U.S. economy, the manufacturing sector is the most important macro indicator affecting their relative performance. The latest data shows that U.S. manufacturing has expanded for the ninth consecutive month, marking the longest period of expansion since 2022. At the same time, small-cap stock valuations have fallen to a four-month low, and revenue and earnings growth in the coming quarters are also expected to outpace large-cap stocks.

Bank of America strategist Jill Carey Hall stated that, from a historical perspective, U.S. mid- and small-cap stocks are currently "very cheap" relative to large- and mega-cap stocks. She pointed out that while valuations are not necessarily a good indicator of short-term entry timing, they are typically stronger predictors over the long term.

This view is particularly noteworthy for investors in small-cap stocks that have recently experienced significant pullbacks. Over two-thirds of the revenue for Russell 2000 Index constituents comes from within the U.S., making them more sensitive to the U.S. economy and the manufacturing cycle. Data shows that in the three months ending in September, the Russell 2000 Index fell a cumulative 7.5%, making it one of the worst quarters relative to the S&P 500 Index this century.

The recent pressure on small-cap stocks is mainly due to ongoing inflationary pressures, Federal Reserve rate hikes, and surging U.S. Treasury yields. For small-cap companies, which usually have higher financing needs and more limited access to financing than large enterprises, rising interest rates mean higher costs for debt servicing and refinancing, making them more sensitive to changes in interest rates.

The upcoming earnings season could be another catalyst for a rebound in small-cap stocks. Bloomberg Industry Research strategist Nathaniel Welnhofer pointed out that the indicator measuring the upward and downward revisions of revenue expectations for Russell 2000 constituents is currently near its highest level since 2022, indicating analysts are becoming more optimistic about these companies’ revenue prospects.

Looking beyond the third quarter, the market expects small-cap stocks’ revenue growth to average 11.2 percentage points higher than S&P 500 constituents over the next four quarters, with earnings growth also likely to outpace large caps.

Meanwhile, the balance sheet positions of small-cap companies have also improved compared to the past. According to Jefferies strategist Steven DeSanctis, the debt-to-capital ratio for Russell 2000 Index constituents is currently about 33.9%, the lowest level since 2021. Lower leverage means some companies are now better positioned to withstand a high interest rate environment than in the past.

However, small-cap stocks have still noticeably lagged behind large technology stocks recently. The Russell 2000 Index fell 0.6% on Tuesday, down a total of 7.8% from the record high set in August. In contrast, the S&P 500 Index and Nasdaq 100 Index both rose 0.6% and 0.5%, respectively, both reaching record closing highs.

Seasonal factors have also weighed on small-cap stocks. Since the beginning of this century, September has consistently been the worst month on average for the Russell 2000 Index, with an average decline of 1.3%. This September, the index fell 5.4%, marking its worst September performance since 2023.

For investors expecting small-cap stocks to regain upward momentum in the coming weeks, Susquehanna strategist Christopher Jacobson suggests focusing on the iShares Russell 2000 ETF (IWM.US) 290/300 dollar call option spread strategy expiring at the end of October. However, the options market currently does not show obvious one-sided optimism. The indicator measuring the difference in demand between call options betting on a 10% rise in the Russell 2000 and put options protecting against a similar decline is only slightly above its historical average, meaning overall market sentiment remains relatively balanced.

The trend in interest rates remains one of the biggest variables determining whether small-cap stocks can truly reverse their losses. While the S&P 500 has so far withstood the pressure from the 10-year U.S. Treasury yield rising to its highest level since 2002, small-cap stocks have been hit much harder.

DeSanctis believes that if the further rise in the 10-year Treasury yield is driven by factors such as faster economic growth, small-cap stocks still have the potential to outperform the broader market. Therefore, investors will closely monitor the Federal Reserve's upcoming interest rate meeting at the end of October, as well as the soon-to-be-released minutes from the September monetary policy meeting. The Fed executed its first rate hike in three years at the September meeting.

Welnhofer said that the factors currently restraining small-cap stocks are quite similar to those affecting companies within the S&P 500 Index, excluding the mega-cap technology stocks. If the upcoming earnings season is strong, it could provide support for small-cap stocks and the broader U.S. equity market; otherwise, investors may need to wait for more dovish signals from the Federal Reserve before expecting small-cap stocks to achieve more sustained rebound momentum.