Bank of America: If these two indicators are triggered, the rally in small caps may continue!

Recently, small-cap stocks have finally ushered in their moment of glory after years of lagging behind, but can this momentum continue? A recent study by Bank of America outlined two specific indicators that, if triggered, could sustain the upward trend of small-cap stocks.

According to the bank, based on model calculations, when the 10-year US Treasury yield remains below 4% and the ISM Purchasing Managers' Index (PMI) rises above 50, the equal-weighted S&P 500 Index (SPW) outperforms the market-cap-weighted S&P 500 Index (SPX), which is more susceptible to the influence of large-cap tech stocks. SPW is considered a good indicator of small-cap strength.

Bank of America analysts wrote: "Historically, when the model is triggered, SPW outperforms SPX 90% of the time, with an average outperformance of 6.3 percentage points."

The specific calculation method for the two signal points of the model is for the 10-year US Treasury yield to drop more than 1% from its 12-month peak and for the ISM PMI to rise more than 4 points from its low point.

Following unexpectedly mild inflation data in June, small-cap stocks gained momentum, boosting market confidence in an imminent Fed rate cut. Investors currently see a 93.6% probability of the Fed easing policy starting in September.

As a result, investors are increasingly keen on embracing industries expected to benefit from lower borrowing costs. These stocks are typically sensitive to leverage and may see significant gains in the coming months.

The Russell 2000 Index, focused on small-cap stocks, has surged by over 12% in July, before narrowing its gains. For Bank of America, its recent highs mark the largest move since March 2020.

For most of this year, high interest rates and frenzied trading in large-cap tech stocks have limited the momentum of the Russell 2000 Index. But as investors start to buy into this overlooked index, some see it as evidence of a broad market rotation.

Tom Lee of Fundstrat stated last week: "I think August will be a time when rotation becomes more evident, with small-cap stocks outperforming and the S&P 500 Index potentially remaining flat or slightly declining." He expects the Russell 2000 Index to have a 40% upside potential.

However, some remain skeptical. Barclays found that small-cap stocks do not always outperform the S&P 500 Index after the Fed's first rate cut. In fact, analysts say that the Russell 2000 Index often declines after a Fed rate cut.

Currently, both the 10-year US Treasury yield and PMI data have not met the two criteria proposed by Bank of America. While the 10-year US Treasury yield has gradually declined since its peak in May, it still remains above 4%. Meanwhile, the manufacturing PMI fell to 48.5 in June Bank of America analysts stated: "The manufacturing economy is currently experiencing the second longest downturn in history, with no PMI exceeding 50 for more than 2 months in a row for 21 consecutive months. We believe that a large part of this is caused by destocking cycles, and we expect this situation to improve in the second half of the year."