Bullish calls from Wall Street's major banks are on the rise. Is it the "spring" for US small-cap stocks?

The "spring" of US small-cap stocks seems to have arrived.

Last week, with the market welcoming the easing of expectations for a Fed rate cut and positive news on Trump's trade, the important index of US small-cap stocks - the Russell 2000 Index has recently shown strength, outperforming the S&P 500 Index. Investors are starting to bet on the rotation of US stocks with real money: the demand for call options related to the Russell 2000 Index has surged.

Wall Street's bullish voices on small-cap stocks are gradually emerging, with Wells Fargo and Morgan Stanley both pointing out that financial and energy stocks, as well as small-cap growth stocks, are expected to perform well.

Russell 2000 Index starts to catch up, outperforming large-cap stocks

With the market's expectations for a Fed rate cut heating up, lower interest rates may help expand the stock market's rally. The first half of the year's rally in US stocks was mainly led by a few large-cap companies such as NVIDIA (NVDA.US). However, the highlight of last week undoubtedly lies in the performance of US small-cap stocks, which once again outperformed the S&P 500 Index dominated by large-cap stocks last Friday after a strong performance on Thursday. Among them, the small-cap benchmark - the Russell 2000 Index, achieved its best weekly performance since 2024. Especially, small and mid-cap stocks outperformed the Magnificent 7, the seven tech giants that have led the entire US stock market since 2023.

This week, small-cap stocks continue to outperform large-cap stocks. Since the rebound began last week, the index has broken through a trading range of over two years. On Tuesday, the Russell 2000 Index outperformed the S&P 500 Index for the fourth consecutive trading day. On Tuesday, supported by increased bets on rate cuts starting this year, the continued downward trend in US Treasury yields, the Russell 2000 small-cap index recorded a fifth consecutive day of gains, closing up 3.5% on Tuesday, with a cumulative gain of 12% in the past five trading days, and a year-to-date gain of 11%. The Russell 2000 Value Index has risen by 8.6% this year, while the Russell 2000 Growth Index has risen by 14.9%. The S&P 500 Index has surged by nearly 19% in 2024.

Matt Miskin, Co-Chief Investment Strategist at investment management firm John Hancock, said that lower interest rates may help market sectors that have been affected by the surge in large-cap tech stocks due to higher rates. This includes small-cap companies, which are often more sensitive to interest rates because of their higher dependence on financing. He said: "In many cases, small-cap companies need capital to survive, and the rise in the cost of capital poses a real challenge to their business. Lower capital costs will certainly help these companies." Moreover, Dan Wantrobski from Janney Montgomery Scott stated that one of the biggest issues in the market on the previous trading day was whether it was a reversal of the trend over the past year and a half or just a mere probe. He said: "We would start by saying that, from a technical perspective, we cannot confirm that yesterday's action is the beginning of a sustainable long-term trend. However, from a trading trend perspective, we do believe that we may continue to see further rotation of trading themes to small and mid-cap stocks in the short term, as technical charts still indicate the possibility of mean reversion."

Investors pour real money into small-cap stocks, with a surge in demand for call options related to the Russell 2000 Index

According to Mandy Xu, Director of Derivatives Market Intelligence at the Chicago Board Options Exchange (Cboe Global Markets), in the past few trading days, there has been a significant increase in demand for call options related to the Russell 2000 Index and exchange-traded funds (ETFs) tracking the index, driving these contracts to trade at a premium relative to put options.

This indicates that there may still be upside potential for the rebound of small-cap stocks in the short term. Xu pointed out that a similar pattern also emerged at the end of 2023, when investors boosted stocks expected to benefit significantly from a substantial Fed rate cut. FactSet data shows that the Russell 2000 Index rose by over 20% from early November to early December last year, outperforming the S&P 500 Index and the Nasdaq Composite Index.

Xu stated: "In the fourth quarter of last year, we saw extreme bullish sentiment in small-cap stocks, but it gradually faded as expectations of rate cuts diminished. Will this time be different?"

Call options give traders the right to buy the underlying stock or ETF at a predetermined price before the option expires. Similarly, put options give traders the right to sell. Options contracts related to indices are usually cash-settled.

Data from Dow Jones Market Data showed that last Thursday, the trading volume of call options related to the Russell 2000 Index and the iShares Russell 2000 ETF reached the highest level in recent years. Nearly 2.1 million call options related to the ETF changed hands that day, marking the highest daily trading volume since December 2009 and the sixth highest since 2005. The trading volume of call options directly related to the index reached the highest level since 2021.

The data indicated that last Thursday was the best day for the Russell 2000 Index since November last year. Demand for call options has remained high since that day. Data showed that on Friday and Monday, the trading volume of call options related to the iShares ETF was more than three times the average daily volume of the past two years.

U.S. small-cap stocks "welcoming" rate cut speculation, with Morgan Stanley recommending investment in small-cap growth stocks

Morgan Stanley's US stock strategist suggests that as the Fed may cut interest rates, investors should consider investing in small-cap growth stocks. Katy Huberty, Global Research Director at Morgan Stanley, stated in a report on Tuesday that strategists' "subtle relative judgments" on US small-cap stocks indicate a preference for increasing holdings in growth stocks rather than value stocks.

Huberty mentioned during a Microsoft conference call: "As yields decline, long-duration small-cap stocks oriented towards growth and more sensitive to changes in capital costs benefit relatively, while small-cap stocks sensitive to the economy (i.e. value) do not benefit."

Morgan Stanley strategists state that due to earnings revisions, there is greater relative upside potential in trading small-cap growth stocks. Huberty also noted that historically, when the Fed starts cutting rates, growth-oriented small-cap stocks tend to outperform. Biotech stocks are potential winners as the industry holds the largest weight in the Russell 2000 small-cap index. She mentioned that biotech "has a strong relative performance record after the Fed starts cutting rates."

Last week, after June CPI data showed a further decline in inflation towards the Fed's 2% target, investors began shifting from large-cap tech stocks dominating the S&P 500 index to small-cap stocks. Traders are currently digesting the possibility of at least two Fed rate cuts, reviving the market theme earlier this year surrounding multiple Fed rate cuts.

Wells Fargo: Trump Trade Boosts Small-Cap Stocks, Calls Small Financial and Energy Stocks the Biggest Beneficiaries

Wells Fargo Securities stated on Tuesday that the rise in small-cap stocks in the Russell 2000 index was driven by enhanced expectations following Trump's victory in November. Wells Fargo stock analyst Christopher Harvey stated in a report on Tuesday that the "political tailwind" overshadowed concerns about corporate earnings.

Monday was the first trading day after Trump was shot in Pennsylvania last Saturday. Harvey cited RealClear Politics, a polling website, saying that after that incident, the likelihood of Trump winning the presidency rose from a low of 57% a week ago to a high of 66%.

Harvey mentioned that small financial and energy stocks can be said to be the biggest beneficiaries of Trump's victory; for heavily regulated industries (such as finance, energy), this is a positive development that may shift focus from earnings to valuation multiples. He also added that Bank of America is monitoring the market's reaction to the ongoing second-quarter earnings season. Currently, bad news for companies is seen as bad news. Our focus has shifted to determining whether the political climate will cause investors to overlook recent negative news.

Despite small-cap stocks starting to rise last week, supported by a cooling off of the US June CPI which fueled bets that the Fed will start cutting rates in September, small-cap stocks continued to rise; however, Harvey stated that they believe the surge in small-cap, value, and cyclical stocks after the data release was a "short-term spike" rather than the beginning of a sustained market cycle, as investors still seem skeptical about corporate earnings. Harvey said that the performance of small-cap stocks on Monday seems "less related to the Fed/interest rates and more to the 'Trump trade' effect"