"Dovish Easterly Winds" ignite a rebound in US small-cap stocks! Traders heavily bet on the continuation of the uptrend.

Traders are making bullish bets on small-cap stocks in the US, despite small-cap stocks struggling to outperform large-cap stocks over the past year. The growing expectations of a rate cut by the Federal Reserve are driving investors to take a more positive view of small and medium-sized publicly traded companies that will benefit from low interest rates. Data shows that in the five trading days leading up to last Friday, the Russell 2000 index rose by 8.5%, and the index has risen by 12.12% year-to-date, accounting for more than 70% of the total cumulative increase this year. The open interest in bullish call options on the iShares Russell 2000 ETF, the largest exchange-traded fund tracking the index, has reached its highest level since September, indicating optimism in the market for a continued rebound. Christopher Jacobson, Co-Head of Derivatives Strategy at Susquehanna International Group, stated in a client report, "After suffering from more hawkish rate cut expectations, small-cap stocks have become the main beneficiaries of recent dovish sentiment." Companies listed on the Russell 2000 index primarily rely on short-term borrowing for their operations, making them more sensitive to changes in short-term interest rates. Federal Reserve officials' recent comments have reignited market expectations for a rate cut by the Fed in December. According to the CME Group's "FedWatch" tool, traders are currently expecting an 87.6% probability of a 25-basis-point rate cut by the Fed this month, compared to just 30% on November 19. Meanwhile, news about the Trump administration appointing a more dovish Fed chairman next year has also been favorable for small-cap stocks. Furthermore, the relative cost of Russell 2000 index call options has decreased, making bullish bets on small-cap stocks more attractive. With reduced demand for protection against further declines in the Russell 2000 index, the skew of call options (measuring the relative cost of more purchased call options) remains low, providing investors with an opportunity to bet on the rise of small-cap stocks. According to compiled data, on Tuesday, a trader paid approximately $1.4 million in option premium to buy call options on the iShares Russell 2000 ETF that would profit if the ETF rose above $255 by December 12. The ETF's closing price on Friday was 2.5% below that level. In addition, another trader is betting that the ETF will rise by 8% before February next year. Chris Murphy, Co-Head of Derivatives Strategy at Susquehanna, stated, "From short-term call options in December to longer-dated structures, bullish positions in the market are continuing to increase across multiple expiration dates." Jonathan Krinsky, Managing Director and Chief Market Technician at BTIG, believes the recent breakout of small-cap stocks "is more likely to continue." Michael Wilson, Chief U.S. Equity Strategist and Chief Investment Officer at Morgan Stanley, pointed out last week that despite recent market pullbacks, particularly impacting high momentum and high beta growth stocks, the current weakness may signal a positive outlook for the medium term. He added that weak employment data will force the Fed to adjust, emphasizing the overweighting of small-cap stocks and non-essential consumer sectors, pointing out encouraging signs that suggest "profit momentum breadth remains resilient even in recent selling, and small cap stocks show the biggest potential upside in forward earnings expectations." Historical data also supports the bullish sentiment towards small-cap stocks. According to data compiled by Bespoke Investment Group, as of last Tuesday, the Russell 2000 index had three consecutive trading days with gains of at least 1.5%. In the 19 other instances in history when this occurred, the small-cap index performed at par in the following month, but achieved above-average gains in the subsequent three, six, and twelve months. However, compared to large-cap stocks, small-cap stocks are still underperforming. The 12.12% increase in the Russell 2000 index year-to-date is lower than the 16.45% increase in the S&P 500 index over the same period. If small-cap stocks were to underperform large-cap stocks again this year, it would be the fifth consecutive year of underperformance, matching the record set in the 1990s to become the longest continuous underperformance in history.