Even though small cap stocks in the US suffered more impact than large cap stocks in September, their performance in the third quarter still outperformed the S&P 500 index.
Liz Ann Sonders, the Chief Investment Strategist at Charles Schwab, said in a phone interview on Thursday, "Overall, the Federal Reserve explicitly stated at the Jackson Hole Economic Symposium at the end of August that they will adopt looser policies, which has boosted small cap stocks." She explained, "Small cap stocks usually perform well during interest rate cutting cycles, especially when the Federal Reserve lowers rates in response to a recession and investors hope to prepare for economic recovery."
But Sonders also pointed out, "We are currently not in an economic recession." Despite the economic slowdown, she added, "The economic performance is still good."
According to FactSet data, the benchmark for small cap stocks in the US $Russell 2000 Index (.RUT.US)$ rose 4% this quarter, despite a 4% decline as of Thursday this month. In comparison, the S&P 500 index only rose 2.5% in the third quarter, but it still significantly outperformed small cap stocks this year.
Investors expect the Federal Reserve to announce a start to lowering its benchmark interest rate, which has been at high levels since July 2023, after Wednesday's policy meeting. The Fed had previously raised interest rates to counter the sharp rise in US inflation, which has significantly eased to near the 2% target after reaching its peak in 2022.
According to the CME FedWatch tool, as of Thursday, traders in the federal funds futures market expect a 69% probability that the Fed will lower the policy interest rate by 25 basis points to a target range of 5% to 5.25% at this meeting.
For investors who hope for a larger rate cut by the Fed, Sonders warns, "Be careful what you wish for." She explains that larger rate cuts typically occur during economic recessions or financial crises.
The recent rebound in small cap stocks has somewhat stalled as traders adjusted their expectations for the rate cut from 50 basis points to 25 basis points. Sonders says, "This may trigger profit-taking in small cap stocks, as overall, small caps tend to benefit more from rate cuts than large companies."
However, Sonders also reminds us that the small cap market is very diverse and not "homogenous." Within the Russell 2000 index, there is a wide variation in stock performance, with low quality stocks often performing differently from high quality stocks.
Sonders points out, "The economy is slowing, but not entering an acceleration phase." Therefore, if investors are looking for opportunities in small cap stocks, they should "focus on high quality companies."
The S&P SmallCap 600 index typically includes higher quality stocks than the Russell 2000 index, as it employs an "earnings filter," according to Sonders. Investors can use it as a benchmark when screening for investment opportunities.
On Thursday, small cap stocks outperformed the S&P 500 index. The Russell 2000 index rose 1.2%, and the S&P SmallCap 600 index also rose 1.2%, both outpacing the 0.7% gain in the S&P 500 index.
On Thursday, the US stock market generally rose, with the blue chip indicator Dow Jones Industrial Average up nearly 0.6%, and the technology-heavy Nasdaq Composite Index up 1%. As of 2024, the S&P 500 index has accumulated a gain of 17.3%, far surpassing the Russell 2000 index's slight gain of over 5% year-to-date, despite a poor performance in September. According to FactSet data, the S&P 500 index has fallen 0.9% this month as of Thursday, while the Russell 2000 index has dropped 4% in September.
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