3 Factors That Could Give Struggling Small-Cap ETFs a Boost

Small-cap stocks, represented by the Russell 2000, have underperformed larger peers year-to-date, with the iShares Russell 2000 (IWM) down 6.2%. A rebound in consumer sentiment in May, driven by easing US-China trade tensions and reflected in a Consumer Confidence Index jump to 98.0, offers potential upside. Earnings growth for the S&P 600 is expected to resume in 2025, and potential Federal Reserve interest rate cuts, contingent on trade deal progress, could further benefit small-cap performance, though the Russell 2000's P/E ratio of 31.05 suggests valuations are not particularly cheap.

Analysis

Small-cap stocks, as benchmarked by the Russell 2000 Index, have demonstrated significant underperformance relative to their large-cap counterparts year-to-date, with the iShares Russell 2000 ETF (IWM) declining by approximately 6.2%, contrasting with gains in the S&P 500 (around 1%) and the Nasdaq-100 ETF (QQQ, up 1.9%). This divergence is attributed to higher borrowing costs impacting capital expenditure and renewed inflationary fears dampening consumer confidence. However, several factors suggest a potential shift: U.S. consumer sentiment saw a substantial rebound in May, with the Consumer Confidence Index jumping 12.3 points to 98.0, well above consensus estimates, driven by optimism over easing U.S.-China trade tensions following a decision on May 12 to halt severe tariffs. For S&P 600 companies, earnings growth is anticipated to resume in 2025 after two years of declines; Q1 2025 earnings are projected to rise 2.9% year-over-year on 2.3% higher revenues, with the outlook for the subsequent three quarters of 2025 indicating more robust small-cap earnings growth of 0.8%, 27.2%, and 13.7%, respectively. Furthermore, potential Federal Reserve interest rate cuts, contingent on successful trade agreements and a consequent reduction in inflationary pressures, could provide an additional tailwind, building on the positive market reaction to the monetary easing cycle initiated in September 2024. Despite these potential catalysts, valuation remains a key consideration: the Russell 2000's P/E ratio stood at 31.05 as of May 23, 2025, up from 27.63 a year prior and comparable to the Nasdaq 100's P/E of 31.25X, suggesting small-caps are not distinctly undervalued. Notably, certain small-and-mid-cap ETFs, such as ProShares S&P MidCap 400 Dividend Aristocrats ETF (REGL) and iShares MSCI USA Small-Cap Min Vol Factor ETF (SMMV), have outperformed the Russell 2000 year-to-date and trade at lower P/E ratios (20.67X and 24.52X respectively).

Key Decisions for Investors

• Given the potential for a cyclical recovery in small-caps driven by improving consumer sentiment, projected earnings growth resumption in 2025, and the prospect of Fed rate cuts, investors could consider a tactical increase in exposure to this segment, particularly if U.S.-China trade relations continue to stabilize.
• Investors should approach small-cap allocations with a degree of caution due to current valuations; the Russell 2000 P/E of 31.05 suggests selectivity is paramount, potentially favoring specific ETFs that have demonstrated relative strength and offer more attractive valuation metrics, such as those with lower P/E ratios and positive year-to-date performance.
• Closely monitor developments in U.S. trade policy, inflation trends, and Federal Reserve communications, as these factors will be critical determinants of the timing and magnitude of any sustained small-cap outperformance.