Small-Cap Stocks Beat S&P 500 as Fed Cuts Loom

On Thursday, the small-cap-focused Russell 2000 index surged, reflecting the strength of U.S. small-cap stocks, which have been outperforming the S&P 500 during the third quarter. Despite facing greater losses than large-cap stocks in September, small-caps are showing resilience.

“Small caps received a boost when the Federal Reserve signaled a move toward easier monetary policy,” said Liz Ann Sonders, chief investment strategist at Charles Schwab, during a Thursday phone interview. This policy shift became clear during the Jackson Hole Economic Symposium in late August. “Historically, small caps tend to perform well during a rate-cutting cycle,” she added, although this effect is typically more pronounced when the Fed cuts rates in response to a recession.

“But we’re not in a recession,” Sonders clarified. “While the economy is slowing, it remains relatively strong.”

The Russell 2000, an index tracking small-cap stocks, has gained 4% this quarter, even after a 4% decline in September. In comparison, the S&P 500, which measures large-cap stocks, has posted a smaller 2.5% gain for the quarter but remains far ahead for the year overall, according to FactSet data.

Investors are anticipating that the Federal Reserve will announce a rate cut at its upcoming meeting, marking a shift from the elevated levels held since July 2023. This period of high rates followed a series of hikes aimed at curbing inflation, which peaked in 2022 but has since moderated towards the Fed’s 2% target.

According to CME’s FedWatch Tool, traders on Thursday saw a 69% chance that the Fed will lower rates by a quarter percentage point to a range of 5% to 5.25%. Sonders warned that investors seeking a larger cut should “be careful what you wish for,” as steeper reductions usually come during recessions or financial crises.

The recent rally in small-cap stocks has cooled slightly as expectations for rate cuts have shifted from a half-point to a quarter-point decrease, leading to some profit-taking. Small-cap stocks typically benefit more from rate cuts than larger companies, Sonders noted.

However, she also emphasized the importance of focusing on quality when investing in small-caps. The Russell 2000 contains a wide variety of stocks, and their performance can vary significantly based on their quality. “The economy is slowing, so if you’re looking for opportunities in small-cap stocks, it’s important to focus on higher-quality names,” Sonders advised.

The S&P Small Cap 600 index, which uses a profitability filter, generally comprises higher-quality stocks than the Russell 2000, according to Sonders, and may be a better starting point for investors.

On Thursday, small-cap stocks outperformed the broader market, with both the Russell 2000 and S&P Small Cap 600 rising 1.2%, surpassing the S&P 500’s 0.7% gain. U.S. stocks overall finished higher, with the Dow Jones Industrial Average up 0.6% and the tech-heavy Nasdaq Composite advancing 1%.

Year-to-date, the S&P 500 has risen 17.3%, significantly outpacing the Russell 2000’s 5% gain, despite a recent dip in September. According to FactSet, the S&P 500 is down 0.9% this month, while the Russell 2000 has slumped 4%.