Will Small-Cap ETFs be Able to Sustain the New-Found Optimism?

U.S. small-cap stocks are demonstrating a potential resurgence, with the iShares Russell 2000 ETF (IWM) gaining 6.3% over the past month, significantly outpacing the S&P 500, despite lagging year-to-date. This renewed interest is largely driven by near-record institutional inflows, including $1.5 billion from Bank of America clients, and high expectations for a September Federal Reserve rate cut (97.6% probability). While Q2 earnings for small caps showed an 8.6% increase, they still trail large-cap growth, and valuations remain elevated with the Russell 2000 P/E at 32.75. The mixed economic outlook, featuring robust Q2 GDP but declining job openings, suggests potential headwinds, yet value-oriented small-cap ETFs have recently outperformed, indicating a shift in segment leadership.

Analysis

U.S. small-cap equities are exhibiting renewed momentum, driven by expectations of a forthcoming Federal Reserve rate cut. The iShares Russell 2000 ETF (IWM) has outperformed the S&P 500 over the past month, gaining 6.3% versus 2.0% for the SPDR S&P 500 ETF (SPY), spurred by near-record institutional inflows, including a $1.5 billion weekly purchase by Bank of America clients. However, this optimism is tempered by several fundamental and macroeconomic factors. While Q2 earnings for the S&P 600 grew a respectable 8.6% year-over-year, this performance, along with EPS and revenue beat rates, trails that of their large-cap S&P 500 peers, who posted 12.4% earnings growth. Furthermore, small-cap valuations appear stretched, with the Russell 2000's P/E ratio at 32.75, a significant premium to the S&P 500's 25.15 and well above its own year-ago level of 27.79. The economic outlook remains mixed; strong Q2 GDP growth of 3.3% contrasts with a softening labor market, evidenced by a larger-than-expected drop in July job openings, posing a risk to these domestically-focused companies. Notably, within the segment, value-oriented ETFs like RZV (+11.0% last month) have been a key source of recent strength, significantly outperforming growth-focused counterparts.

Key Decisions for Investors

• The rally in small-caps is highly contingent on the Federal Reserve initiating a rate-cutting cycle, making upcoming FOMC meetings and inflation data critical watchpoints for sustaining momentum.
• Given the Russell 2000's elevated P/E ratio of 32.75 and earnings growth that trails large-caps, investors should be cautious of the segment's high valuation and may require further fundamental improvement to justify broad-based buying.
• Consider focusing exposure on small-cap value and momentum factor ETFs, such as RZV and XSVM, which have demonstrated significant outperformance relative to growth and broad-market small-cap funds in the recent environment.
• Monitor domestic economic indicators, particularly labor market data like the JOLTS report and consumer spending trends, as any marked deterioration could disproportionately hinder small-cap performance.