To The Moon

Despite facing a tougher September compared to large caps, U.S. small caps outperformed the $S&P 500(.SPX)$ in the third quarter.

Liz Ann Sonders, Chief Investment Strategist at Charles Schwab, noted:

“Overall, the Fed’s clear signal for a more accommodative policy at the Jackson Hole symposium in late August has buoyed small caps. Small caps typically thrive during rate-cutting cycles, especially when the Fed cuts rates to combat a recession, as investors prepare for economic recovery.”

However, Sonders also pointed out, “We are not in a recession yet. Despite the economic slowdown, the economy is still performing reasonably well.”

According to FactSet, the Russell 2000 Index $iShares Russell 2000 ETF(IWM)$ , a benchmark for U.S. small caps, rose 4% this quarter, though it has fallen 4% this month through Thursday. In contrast, the S&P 500 only gained 2.5% in Q3, but it has significantly outperformed small caps this year.

Investors are anticipating that the Fed will announce a rate cut after its policy meeting on Wednesday, starting to reduce the benchmark rate that has been high since July 2023. The Fed had previously raised rates to tackle soaring inflation, which has significantly retreated to near the 2% target since peaking in 2022.

As of Thursday, CME FedWatch tool data showed a 69% probability that the Fed would cut the policy rate by 25 basis points to a target range of 5% to 5.25%.

For those hoping for a more substantial rate cut, Sonders advised, “Be cautious of what you wish for.” She explained that larger cuts usually occur during economic recessions or financial crises.

Small Caps Set for Rally

Recently, small cap stocks have experienced a “stall” as traders adjusted expectations for the rate cut from 50 basis points to 25. Sonders noted that this “could trigger profit-taking in small caps, as they generally benefit more from rate cuts than large companies.”

However, Sonders also cautioned that the small cap market is vast and not “homogeneous.” Within the Russell 2000, there is significant variation in stock performance, with low-quality and high-quality stocks behaving differently.

Sonders suggested, “With the economy slowing but not accelerating, investors looking for opportunities in small caps should focus on high-quality companies.”

The S&P SmallCap 600 Index often includes higher-quality stocks compared to the Russell 2000 due to its “earnings filter,” according to Sonders. Investors might use it as a benchmark when screening for investment opportunities.

On Thursday, small caps outperformed the S&P 500. The Russell 2000 rose 1.2%, and the S&P SmallCap 600 also gained 1.2%, both beating the S&P 500’s 0.7% increase.