Small-cap stocks are on a volatile streak. Should investors bet on a turnaround?

For the week, the Russell 2000 advanced 1.1%, outperforming the tech-heavy Nasdaq Composite
COMP,
which fell 1.3%, by the widest margin since the week ending Dec. 15 of last year. Additionally, the S&P 500
SPX
fell 0.4% for the week while the Dow Jones Industrial Average
DJIA
was off 0.1%, with all three major large-cap indexes snapping five-week winning streaks, according to Dow Jones Market Data.

“Small caps are almost directly a ‘Fed story’ or a ‘rates story,’” said Anna Rathbun, chief investment officer at CBIZ Investment Advisory Services. “You see more volatility in small caps because of their dependency on rates,” she told MarketWatch in a phone interview on Thursday.

Investors usually see small-cap stocks getting punished when there is market sentiment that interest rates will stay higher for longer, and recovering on signals that the central bank’s monetary-tightening cycle might be over, Rathbun said.

On Tuesday, a steep selloff across U.S. stock and government-debt markets after a hotter-than-expected January inflation report dragged the Russell 2000 down nearly 4% — its worst day since June 2022 — as investors confronted the bitter possibility that interest rates will stay higher for months longer than they had hoped. 

However, investors breathed a sigh of relief over the following trading days, after dovish comments from Chicago Fed President Austan Goolsbee and a weak retail-sales report revived hopes for a first rate cut from the Fed in the coming months. The Russell 2000 ended around 2.5% higher on Thursday, notching its best daily percentage gain since December, according to FactSet data. 

See: Beaten-down small-cap stocks are roaring back. Why they could soar in 2024.

Earlier this year, some investors bet on a significant resurgence for long-suffering small-cap stocks, with hopes that the sector’s brief outperformance in December could have legs in the new year as interest rates come down and the U.S. economy proceeds toward a soft landing. 

Yet the Russell 2000 has risen only 0.3% so far this year, compared with a 4.9% advance for the S&P 500 and a 5.1% gain for the Nasdaq over the same period, according to FactSet data. 

David Lefkowitz, head of equities for the Americas at UBS Global Wealth Management, said small-cap stocks are close to playing catch-up to their large-cap peers after being left in the dust in 2023, as periods of negative correlation between interest rates and small caps tend to be short lived. 

“We don’t see why this time would be any different, but even if this correlation remains intact, our fixed-income team’s outlook for the 10-year Treasury yield to fall to 3.5% by the end of the year should be supportive for small-cap outperformance in the months ahead,” Lefkowitz and his team said in a client note from last week.

The yield on the 10-year Treasury bond
BX:TMUBMUSD10Y
settled at 4.294% on Friday afternoon, after advancing 10.8 basis points this week, according to Dow Jones Market Data.

Meanwhile, the chart below shows that it’s more common for small caps to outperform when rates are rising and economic growth remains solid. But Lefkowitz and his team admitted that the recent rise in rates hasn’t led to small-cap outperformance because pickup in earnings growth has not yet “convincingly come through.”

Indeed, a resilient U.S. economy is typically required to support small-cap companies’ outperformance, but the volatility in the Russell 2000 means investors are not convinced that the economy is on the path to achieving a soft landing right now, CBIZ’s Rathbun said.

“What are the small caps pricing in that we may not be thinking about? We keep talking about soft landing, no landing — but we’re still flying midair, and we’re nowhere near the runway right now,” she said.

See: Stock market bounces back from inflation-inspired dive. Here’s the message for investors.

That’s why the “extra volatility” in small-cap stocks over the past week should be better characterized as an “opportunistic rotation” into a lagging sector as the megacap-tech-led rally has broadened out, instead of a “fundamental move” into small caps amid looser credit conditions or a strong U.S. economy, said Steve Sosnick, chief strategist at Interactive Brokers. 

“[Small-cap stocks] move because the money is flowing into them as the momentum carries the stocks along the way — but the downside is many stocks are unprofitable, which means they either need a strong economy or relatively favorable rates in order to borrow money and stay afloat until they can be profitable,” Sosnick told MarketWatch in a phone interview on Thursday. 

Sosnick added that the rotation may only be profitable for those who “successfully catch the waves,” as unless there are signs of either a strengthening economy or easing credit conditions, the Russell 2000 is still likely to experience headwinds that its larger peers will not.