What’s Driving The Rotation Into Small-Cap Stocks? | J.P. Morgan (2024)

Market Update

Volatility is back in equity markets.

• A decline in megacap tech stocks Thursday
• The first day in the last five where small caps have underperformed large caps
• The CBOE Volatility Index (VIX) at its highest level since April

Markets are feeling like a … market.

The S&P 500 (-0.8%) had a broad pullback with 10 of the 11 sectors in the red. Small caps fell nearly -2% in their worst day since April, but are still up more than 7% this month.

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 give 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 has a negative return, including all four companies listed above.

Performance is broadening across the equity market. As we argued last week, we think that can continue.

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. Last week’s Consumer Price Index (CPI) report showed the first month-over-month decrease since 2020, and Bank of America’s (BofA) institutional fund manager survey showed that higher inflation is no longer investor’s 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 a Bank of America survey, almost 40% of investors think that monetary policy is too restrictive – the highest since 2008. That 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, which means they are more dependent on capital markets for financing than large caps who 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 exchange-traded funds (ETFs) 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.

Past performance is no guarantee of future results. It is not possible to invest directly in an index.

Assess portfolio positioning and consider an allocation to Small and Mid-cap (SMID) 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, reach out to your J.P.Morgan advisor, who is here to help.

All market and economic data as of 07/19/2024 are sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.

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The Chicago Board Option Exchange(CBOE) Volatility Index (VIX), is a real-time index that represents the market’s expectations for the relative strength of near-term price changes of the S&P 500 Index.

The Solactive United States 2000 Index intends to track the performance of the largest 1001 to 3000 companies from the United States stock market. Constituents are selected based on company market capitalization and weighted by free float market capitalization.

The iShares Russell 2000 ETF seeks to track the investment results of an index composed of small-capitalization U.S. equities.

The information presented is not intended to be making value judgments on the preferred outcome of any government decision or political election.

Investing in equities involves risk. The price of equity securities may rise or fall due to the changes in the broad market or changes in a company's financial condition, sometimes rapidly or unpredictably. Equity securities are subject to "stock market risk" meaning that stock prices in general may decline over short or extended periods of time.

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