Market sentiment "approaching frenzy" US small-cap stocks show red flags.

Signals of overheating in the US stock market have been frequent, indicating that the recent momentum of some high-risk stocks may fizzle out. In the past month, the S&P 500 index surged to a new all-time high, with small-cap stocks performing even more strongly. Small-cap companies usually have higher debt and lower profitability compared to large-cap companies. However, as investors abandon defensive positions and move into more speculative areas, small-cap stocks have been easily outperforming large-cap stocks. But history shows that when enthusiasm becomes excessive, it may not bode well for small-cap stocks. An investor sentiment indicator from Bloomberg Intelligence has shifted from April's panic mode to June's "approaching frenzy." According to the Bloomberg Intelligence strategy team led by Gina Martin Adams, once the indicator reaches a frenzied level, the market tends to cool off, with small-cap stocks starting to lag behind large-cap stocks. The team noted that between 2012 and 2023, in the three months following a frenzy level in the sentiment indicator, the S&P 500 index outperformed the small-cap benchmark Russell 2000 index by 178 basis points. Since the end of May, small-cap stocks have outperformed large-cap stocks. Mark Hackett, Chief Market Strategist at Nationwide, said, "In general, small-cap stocks are seen as cyclical stocks, performing well in the early stages of a market uptrend and even better during a strong market. However, when the market falls, investors instinctively sell off small-cap stocks." A recent vivid example occurred after the start of US President Donald Trump's second term, when the market surged significantly due to a return in risk appetite. By the end of January, Bloomberg Intelligence's investor sentiment indicator reached an extremely frenzied level. In the following three months, the S&P 500 index fell by 7.8%, while the Russell 2000 index fell by 14%, attributed to the gradual implementation of the new Trump administration's tariff policies and increasing concerns about the future of artificial intelligence. By July, both large-cap and small-cap stocks showed resilience, as there were signs that the US job market remains robust. Focus on the rebound of small-cap stocks Wall Street is focusing on small-cap stocks, as they have historically been seen as important leading indicators, being the first to decline in times of economic turbulence and the first to recover after an economic downturn. Investors are also closely watching whether the strength of small-cap stocks can further expand. A stock market supported by broader gains is considered healthier and more capable of withstanding any sudden shocks. Earlier this month, after the Russell 2000 index broke through its long-term trading range (i.e., the 200-day moving average), some believe the index is poised for further gains. Dennis DeBusschere of 22V Research recommended holding long positions in small-cap stocks. He stated that the slowing but stable US economic growth, accommodative financial conditions, and factors such as tax and spending agreements suggest economic growth in the first half of 2026, which "bodes well for stocks with the greatest risk or economic sensitivity." Countdown to tariff deadline As the key deadline for tariff negotiations between the US and major trading partners approaches, and with economic uncertainty persisting, some strategists suggest choosing assets of larger companies with stronger balance sheets and profitability. Barclays strategist Venu Krishna stated that while Trump's tax legislation may lead to double-digit earnings growth for small-cap companies, given the ongoing decline in economic and survey data, he still favors large-cap stocks. Large-cap companies have improving earnings expectations, higher profit margins, stronger balance sheets, and stand to benefit more from macro growth drivers such as artificial intelligence. Krishna said, "We believe that fundamental factors do not support a trend shift from large-cap stocks to small-cap stocks."