Small caps could be in for a revival. Here’s why

Stocks have endured a brutal stretch, with the Nasdaq now flirting with correction territory since reaching an all-time high on July 10. Even so, a long-awaited rotation out of tech and into small caps — a trend that kicked off a few weeks ago — could still have legs.

While all indexes have taken a beating in recent trading sessions, the Russell 2000 had shown signs of life before the so-called carry trade and worries about the U.S. economy disrupted its best run in years. A small-cap revival would unequivocally be a positive thing.

Indeed, coming after spikes in the S&P 500 and Nasdaq powered by a handful of companies perceived to benefit most from the boom in artificial intelligence, the increased market breadth may provide stocks the boost they need to overcome the recent rough patch.

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Two things need to happen for small caps to regain momentum.

The first is that the Federal Reserve will have to slash rates soon. That seems like a sure thing, with futures markets pricing in a probability of 100% of that happening in September. Notably, this level of certainty is largely responsible for sparking the rotation mentioned above in the first place. 

Secondly, we’ll need to see continued economic growth. This is obviously less certain, with July’s labor market data raising some concerns. Yet, the report is not as bad as some have made it out to be. Remember, recessions typically start with layoffs, which is not what the jobs report showed. The issue was more related to demand.

Therefore, the long-talked-about soft landing may still be possible and rate cuts could deliver a cyclical recovery that benefits small firms. The catch, though, is that these companies experience more volatility than their larger peers.

That’s why a fund tracking small caps is a smart bet. The iShares Russell 2000 ETF (IWM) is the largest one, which, along with the fact that it includes diversified exposure to many small companies, means the ups and downs are more muted.

However, it could be worth taking individual positions in a handful of midcap companies that have underperformed this year but could benefit from a further market rotation. One is Fabrinet (FN), a good way to play the increasing importance of data centers since it’s a leading contract manufacturer of optical components.

Silicon Laboratories (SLAB) and Synaptics (SYNA) are also attractive. Each produces discrete semiconductors, which, unlike integrated circuits, are individual units that perform specific functions. That’s an advantage because they can be more easily customized. 

Finally, Monday.com (MNDY) is also worth considering. It provides small- and medium-size businesses with a cost-effective, multipurpose alternative to expensive, single-use products such as Salesforce and QuickBooks.

One reason to doubt that a prolonged recovery for cyclically sensitive small caps is in the works: the price of copper. The metal usually goes up when cyclicals are poised for an extended rally. Copper prices, however, have fallen steeply since May.

Still, the performance differential between the Russell 2000 and S&P 500 during the spring reached 30 percentage points, a record. Since then, it has only recouped about 6% of that. Moreover, outside of the “Magnificent Seven”, valuations are reasonable. 

Therefore, once all the recent smoke clears and if it becomes apparent that policymakers can pull off a soft landing by cooling inflation and avoiding a recession, rates will come down and the rotation will continue, giving small and midcaps staying power.

— Andrew Graham, founder and managing partner of Jackson Square Capital.