U.S. Economic Resilience Boosts Small-Cap Stock Outlook, Wall Street Expects a Rebound Opportunity

Title context: U.S. Economic Resilience Boosts Small-Cap Stock Outlook, Wall Street Expects a Rebound Opportunity Text: Although soaring U.S. Treasury yields and rising borrowing costs have continued to weigh on U.S. small-cap stocks recently, the resilience shown by the U.S. economy is strengthening the case for a rebound. Bank of America Corp pointed out that for small-cap stocks, which are highly dependent on the U.S. domestic economy, manufacturing is the most important macro indicator affecting their relative performance, and the latest data show that U.S. manufacturing has expanded for a ninth consecutive month, the longest expansion cycle since 2022. At the same time, small-cap valuations have fallen to a four-month low, and revenue and earnings growth over the next few quarters are also expected to outpace large-cap stocks. Bank of America Corp strategist Jill Carey Hall said that, from a historical perspective, U.S. small- and mid-cap stocks are currently "very cheap" relative to large- and mega-cap stocks. She noted that valuation is not necessarily a good indicator for judging short-term entry timing, but over the long term its predictive power is usually stronger. This view is particularly noteworthy for small-cap investors who have recently suffered a notable pullback. More than two-thirds of Russell 2000 constituents' revenue comes from the United States, making them more sensitive to the U.S. economy and the manufacturing cycle. Data show that in the three months through the end of September, the Russell 2000 fell 7.5% cumulatively, one of its worst quarterly performances relative to the S&P 500 this century. The recent pressure on small-cap stocks has mainly been driven by persistent inflationary pressure, Federal Reserve rate hikes, and soaring U.S. Treasury yields. For small-cap companies, which typically have higher financing needs and weaker financing conditions than large enterprises, rising interest rates mean higher debt servicing and refinancing costs, making them more sensitive to changes in interest rates. The upcoming earnings season could become another catalyst for a small-cap rebound. Bloomberg Intelligence strategist Nathaniel Welnhofer pointed out that a gauge measuring upward versus downward revisions to revenue expectations for Russell 2000 constituents is currently near its highest level since 2022, indicating that analysts' views on the revenue prospects of these companies are improving. Looking beyond the third quarter, the market expects small-cap revenue growth over the next four quarters to average 11.2 percentage points higher than that of S&P 500 constituents, with earnings growth also expected to outpace large-cap stocks. At the same time, the balance sheet conditions of small-cap companies have also improved compared with the past. Data from Jefferies Financial Group Inc. strategist Steven DeSanctis show that the debt-to-capital ratio of Russell 2000 constituents is currently about 33.9%, the lowest level since 2021. Lower leverage means some companies are better equipped than in the past to cope with a high-interest-rate environment. Nevertheless, small-cap stocks have recently continued to significantly lag large-cap technology stocks. The Russell 2000 fell 0.6% on Tuesday, down 7.8% cumulatively from its record high set in August; by comparison, the S&P 500 and Nasdaq 100 rose 0.6% and 0.5% that day, respectively, both setting record closing highs. Seasonal factors had also previously weighed on small-cap stocks. Since the start of this century, September has on average been the worst-performing month for the Russell 2000, with an average decline of 1.3%. In September this year, the index fell 5.4%, its worst September performance since 2023. For investors expecting small-cap stocks to regain upward momentum in the coming weeks, Susquehanna strategist Christopher Jacobson recommended watching the iShares Russell 2000 ETF (IWM.US) 290/300 dollar call option spread strategy expiring at the end of October. However, the options market has not yet shown one-sided optimism. A gauge measuring the difference in demand between call options betting on a 10% rise in the Russell 2000 and put options hedging against a similar decline is only slightly above the historical average, meaning bullish and bearish sentiment overall remains fairly balanced. The path of interest rates remains one of the biggest variables determining whether small-cap stocks can truly reverse their slump. Although the S&P 500 has so far withstood the pressure from the 10-year U.S. Treasury yield rising to near its highest level since 2002, small-cap stocks have been hit more noticeably. DeSanctis believes that if the continued rise in the 10-year U.S. Treasury yield is driven by positive factors such as faster economic growth, small-cap stocks could still outperform the broader market. Therefore, investors will closely watch the Federal Reserve's next rate meeting at the end of October, as well as the upcoming minutes of the September monetary policy meeting. At the September meeting, the Federal Reserve raised rates for the first time in three years. Welnhofer said the constraints currently facing small-cap stocks are basically similar to those facing the rest of the S&P 500 excluding mega-cap technology stocks. If the upcoming earnings season is strong, it could provide support for small-cap stocks and even the broader U.S. equity market; otherwise, investors may need to wait for the Federal Reserve to send a more dovish policy signal before small-cap stocks can gain more sustained rebound momentum.