June 13, 2024

Investors haven’t loved small caps this much in nearly three years—and here’s why.

Small caps have been all the craze on Wall Street over the past two months.

In fact, according to Bank of America’s latest fund manager’s survey, investors haven’t been this bullish on small caps in almost three years.

The survey conducted from Jan. 5 – Jan. 11 revealed investors see large cap companies underperforming small cap companies in the next 12 months for the first time since June 2021.

A chart from Bank of America shows sentiment around large caps outperforming small caps has deteriorated in recent months.

A chart from Bank of America shows sentiment around large caps outperforming small caps has deteriorated in recent months. (BofA Global Fund Manager Survey)

Wall Street strategists believe the group of stocks, commonly tracked by the Russell 2000 Index (^RUT), has become increasingly attractive as the prospect of lower interest rates in the year ahead grows. Many have seen the small cap index has undervalued compared to historical norms while also noting it hadn’t fully joined the market rally like such as megacap tech stocks.

In December, Fundstrat head of research Tom Lee noted that he sees megacap tech still holding up well in 2024 but not out performing small caps.

“I think small caps could rise 50% next year easily,” Lee said. “And Financials (XLF) could rise 30% … When it comes to positioning no one owns Financials and no one’s really long small caps. There’s a lot of upside.”

But the market has shifted since Lee initially made his call.

Small caps have ripped higher amid the soft-landing fueled rally, which has seen investors price in roughly six interest rate cuts in 2024 as inflation has fallen faster than many predicted. From late October to mid December, it took just 48 days for the Russell 2000 to rise from a 52-week low to a new 52-week high, marking the fastest turnaround for the index ever, per Bespoke Investment Group.

Now, with the index up over 16% since its October lows, the key question for investors is whether the index has already priced in the future benefits of lower interest rates, limiting the upside in buying small caps.

Goldman Sachs says no.

“The combination of low current valuations and a healthy economic outlook implies that the Russell 2000 should return roughly 15% in the next 12 months,” the Goldman Sachs equity strategy team led by David Kostin wrote in a note to clients on Jan. 12.

A key caveat to this call could be if “investor expectations for economic growth deteriorate.”

Lori Calvasina at RBC Capital Markets has been recommending small cap stocks for months. Much of the Calvasina’s case for why small caps could out perform remains in tact. That is: small cap stocks have outperformed in prior interest rate cutting periods—and their exposure to higher interest rates weren’t as bad as feared. But a key part of Calvasina’s call, that small caps had been oversold, has flipped amid the recent market rally.

NEW YORK, NEW YORK - AUGUST 25: Traders work on the floor of the New York Stock Exchange during morning trading on August 25, 2023 in New York City. Stocks opened up higher as Wall Street awaits a speech from Federal Reserve Chairman Jerome Powell’s at the Jackson Hole Economic Symposium.  (Photo by Michael M. Santiago/Getty Images)

Looking for small caps? Traders work on the floor of the New York Stock Exchange. (Photo: Michael M. Santiago/Getty Images) (Michael M. Santiago via Getty Images)

This has Calvasina “concerned” about how popular small caps have become.

In December it felt like everyone we met with (including the many varieties of investors who are not focused on Small Cap investing) wanted to talk about Small Caps and was constructive on them,” Calvasina wrote in a note on Jan. 8.

She added: “We can’t remember the last time this happened.”

Josh Schafer is a reporter for Yahoo Finance.

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