Investors are flocking to small-cap stocks right now, driving this segment of the market to new highs this week. The Russell 2000 index hit its highest level of 2,194.46 on Monday since January 2022 when the index traded as high as 2,196.74, according to CNBC analysis. The index, which comprises small-cap companies in the U.S. that derive most of their revenues domestically, rose more than 3% on Tuesday for its fifth straight day of gains. Adam Turnquist, chief technical strategist for LPL Financial, said the moves are “signaling a potential breakout” for a sector that has largely been underperforming. He also noted that the Russell 2000 is outperforming the S & P 500 by the widest margin since November 2021. But is the rally sustainable? Turnquist pointed to the fact that June’s U.S. consumer price index declined. With the U.S. Federal Reserve repeatedly saying inflation will need to cool for rate cuts to happen, that’s good news for smaller companies as they generally rely on borrowing to fund operations, he said. “As inflation cools, the expectation that the Federal Reserve (Fed) will cut rates increases, therefore, creating a lower cost of capital for debt-dependent companies,” Turnquist said. But according to him, one group of small-cap stocks could do well if rates were to stay higher for longer: regional banks. He added: “For now, more immediate data points like CPI and Fed projections are igniting small-market-cap names higher. However, at this point, it remains to be seen if a longer-term economic slowdown will balance out the recent step higher.” However, Turnquist cautioned that small-cap growth stocks would find the outlook tougher than small-cap value stocks, as they are more sensitive to economic health. Given those factors, it’s crucial to stock pick among small-cap names, he said. “We don’t want to miss spikes in price appreciation as we’ve recently seen, but if economic weakness indeed persists, we want to be positioned in more profitable segments of the small caps and remain careful. The late-cycle characteristics of this economy and the increase in expected volatility require a watchful and targeted approach at this point,” he explained. There’s also the Trump factor, said Kelvin Wong, senior market analyst at Oanda, in a July 16 note. If former U.S. President Donald Trump wins the upcoming U.S. election in November, he will likely adopt an America-first position and focus on domestic firms, according to Wong. “The playbook of “Trumponomics” policies is likely to be at the forefront under the slogan of “Make America Great Again” where tax cuts and perhaps subsidies may be targeted towards small and medium domestically oriented firms in the US which in turn improve their profitability prospects that may further boost the bullish sentiment towards Russell 2000,” said Wong. But Citi cautioned that, according to history, small-cap stocks tend to underperform before the first rate cut, and outperform only after that happens. “This would also suggest that the big rotation from large caps into small caps may not have that much follow-through,” Citi analysts wrote in a July 11 note. How to play small-caps Investors who have been making a play for small-caps include billionaire Stanley Druckenmiller , who revealed a big bullish position in small-cap stocks last quarter. He bought call options against 3,157,900 shares of the iShares Russell 2000 ETF (IWM) for a stake worth $664 million. According to FactSet, the iShares Russell 2000 ETF has potential upside of 14.4% to the consensus price target given by analysts covering the exchange-traded fund. David Dietze, senior investment strategist at Peapack Private Wealth Management, said this ETF is the “easiest way” to play small-caps. “The expense ratio of the fund is quite low, at 0.19%, and you are diversified over nearly 2000 stocks, with no one stock representing even one half of 1% of the fund. Great liquidity and if small caps do well this will participate,” he told CNBC Pro. Among stocks, he likes apparel maker VF Corp, which owns brands such as The North Face, Timberland and Vans. “Despite its small market cap size it designs and distributes its lifestyle products globally,” said Dietze, adding that the stock has climbed nearly 50% from its recent low despite continuing challenges in the retail sector. Dietze also likes medical devices maker Organon, which has been “largely ignored” but is also up nearly 50% this year. “It … has more debt than perhaps is optimal so OGN could also benefit from easier monetary policy by the Federal Reserve,” he added. Jay Hatfield, chief investment officer of InfraCap, likes small-cap dividend stocks in particular. He names two: investment bank Jefferies and Kilroy , which owns office real estate in the tech and life sciences industries. Jefferies has benefited from a pick-up in merger and acquisition activity, while Kilroy will benefit from artificial intelligence trends and back-to-office mandates, Hatfield said. — CNBC’s Yun Li contributed to this report.
