Market Rotation: Small-Cap Stocks' Era Arrives in US?

The American stock market has seen a massive shift lately, with small-cap stocks finally bursting into life after a long slumber. Amid expectations of an imminent Fed rate cut, the most speculative and risky US small-caps are soaring at a pace unseen since the pandemic.

In the past five trading days, the Russell 2000 Index, a benchmark for small-caps, has surged 12%, marking the strongest rally since April 2020. During this period, the $S&P 500(.SPX)$ index inched up just 1.6%, while the tech-heavy $NASDAQ 100(NDX)$ even dipped 0.3%.

Remarkably, the largest ETF tracking the Russell 2000 saw its weekly fund inflows rank second among equity ETFs last week.

Cole Wilcox, CEO of Longboard Asset Management, noted that before the CPI report, hedge funds and traders held record short positions. The lower-than-expected inflation data caught the market off guard, fueling a violent rally in small-caps.

Will the small-cap rebound last?

Over the past two years, Fed rate cut expectations have repeatedly propelled small-caps upwards, only to fizzle out. During this period, small-cap valuations hit historical lows. Despite the recent rebound, the Russell 2000 is still up just 12% this year, paling in comparison to the S&P 500's 19%.

"Lower valuations combined with Fed rate cuts could spark a very strong rally in small-caps," says Eric Sterner, CIO at Apollon Wealth Management.

The options market also reflects growing bullish sentiment towards small-caps. The implied volatility of one-month options on the $iShares Russell 2000 ETF(IWM)$ hit its highest level since April, while put option premiums fell to their lowest since December.

Can small-caps reclaim their historical glory?

Stats from Professors Eugene Fama and Ken French show that since 1927, small-caps have outperformed large-caps in two-thirds (67%) of 10-year periods, beating them by an average of 285 basis points.

But over the past decade, small-caps have comprehensively lagged behind, posting the widest underperformance gap since the dot-com bubble, and for the longest duration (13 years vs. an average cycle of 12 years).

This has resulted in small-caps trading at their cheapest levels relative to large-caps since 2000. The Russell 2000/Nasdaq 100 ratio has plunged to an all-time low of 0.1, never dipping below 0.12 even during the peak of the dot-com bubble.

Historically, small-caps can't stay cheap forever. A valuation rebound seems inevitable.