Small-cap stocks, represented by the Russell 2000 Index (IWM), surged on Thursday, buoyed by hopes for interest rate cuts following lower-than-expected inflation data.
The U.S. inflation rate rose 3% over the 12 months to June, down from 3.3% in May, marking the slowest price increase in a year. This unexpected slowdown, driven in part by lower petrol prices, has increased market expectations for Federal Reserve rate cuts.
According to Mizuho analysts, "the NASDAQ 100 is trailing the Russell 2000 by 4.20%," marking the NASDAQ's roughest day relative to the Russell 2000 since January 2021.
This significant divergence is said to be rare, having occurred only about six times out of 4,000 trading days since 2008.
The firm says that historically, such unusual swings are followed by a rebound in big tech stocks. They note that "big tech stocks tend to bounce back pretty well (rebounding 60% of the time T+1 and T+5)" after these rare occurrences. This trend suggests potential for a recovery in tech stocks even as small caps enjoy their current boost.
The combination of easing inflation and the prospect of rate cuts has created an environment favorable for small caps as they begin to see more comfortable borrowing costs. The prospect has driven notable gains, highlighting investor optimism in this segment.
A note from BoFA earlier today said that analysts expect improving but still negative earnings year-on-year for small caps in the second-quarter, noting that the revision ratio also still negative.
They also stated: "Small caps remain the only historically cheap size segment (P/E below its long-term average of 15.2x), and the relative P/E of small vs. large at 0.71x remains ~30% below the long-term average of 1.0x.
"Multiples tend to be most predictive over the long-term and today suggest 10% annualized returns for the Russell 2000 over the next decade vs 3% per annum for the Russell 1000."