Small-cap stocks experience remarkable growth, driven by tech trends and economic recovery. Explore key factors behind this surge.
In a remarkable turnaround, small-cap stocks in the U.S. are celebrating their best first half in 35 years. This surge, marked by a nearly 22% rise in the Russell 2000 Index during the first half of 2023, signals a significant shift in market dynamics following prolonged underperformance against larger peers.
This small-cap growth is not merely a reflection of traditional economic cycles; it is largely attributed to the burgeoning investment-tools-amid-valuation-concerns/">artificial intelligence sector and its corresponding infrastructure build-out.
The transformative power of artificial intelligence has become a focal point for investors, with spending cascading beyond tech giants like Nvidia into a wider ecosystem of suppliers and small-cap firms. Unlike their larger counterparts, these smaller companies are not aiming to compete directly with industry leaders; instead, they are well-positioned to benefit from the increased demand for AI-related infrastructure.
Amy Zhang, portfolio manager at Alger, highlights this valuation dynamic, stating, "It's both a valuation catch-up story and a fundamental story. The valuation gap was so wide that a truck could drive through it. At the same time, fundamentals are improving in small-caps, and I think that’s why it’s causing the broadening trade." The inclusion of semiconductor and related companies in the small-cap narrative cannot be overlooked, with firms like Aehr Test Systems and Ichor Holdings seeing stock performance skyrocketing more than 400% this year.
The underlying advantages for small-cap companies include being essential parts of the AI supply chain, ranging from semiconductor manufacturing to connectivity solutions. As larger firms ramp up their AI investments, these smaller entities are reaping significant revenue and profit gains.
While AI undeniably fuels enthusiasm in the small-cap sector, analysts assert that a confluence of additional economic factors supports this category’s revival. Adam Turnquist, chief technical strategist at LPL Financial, notes, "Small-cap leadership has been notable amid the mega-cap-driven bull market, although small caps have meaningful exposure to semiconductors and technology hardware. Building fundamental strength has also helped offset headwinds from higher rates."
The consensus among analysts shows a notable increase in optimism regarding earnings growth for Russell 2000 companies. Forecasts for 2026 earnings growth have surged to 38% from approximately 23% at the onset of the year, indicating that small-cap profit growth is diversifying and expanding beyond the technology behemoths.
Other factors contributing to small-cap strengths include greater sensitivity to the U.S. economy, anticipated increases in merger and acquisition activities (especially in the pharmaceutical and biotechnology sectors), and government tax incentives aimed at bolstering capital investment. As a result, small-cap stocks could carve an increasingly prominent role in the broader market recovery narrative.
Despite the evident momentum behind small-cap stocks, a shadow looms in the form of rising interest rates, which have historically hindered the growth of this asset class. With the Federal Reserve’s next meeting on July 28-29, 2023, traders currently perceive a 30% chance of another rate hike, with market expectations for approximately a 60% likelihood of at least one quarter-point increase by September.
Higher borrowing costs pose substantial challenges for smaller firms due to their typically higher floating-rate debt and refinancing needs compared to large caps. Analysts from Bank of America estimate that each additional 25 basis point hike could reduce operating earnings for Russell 2000 companies by approximately 2%.
Moreover, this tightening cycle could jeopardize anticipated profit increases in the fourth quarter for small caps, as they remain among the most vulnerable to refinancing risks. Nonetheless, many market participants harbor a belief that the most severe impacts of the tightening cycle may have run their course. Zhang observes, "We’re probably close to peak inflation and peak rates. We had significant headwind the last five years, and I think that headwind is going to abate and turning into a tailwind."
As we look toward the second half of 2023, the outlook for small-cap stocks remains optimistic, bolstered by technological advancements in AI and a supportive economic environment. Industry analysts and financial experts continue to observe significant growth and investment opportunities within this sector.
While challenges remain — particularly concerning interest rates and economic conditions — many stakeholders are drawing on the lessons of past performance. The remarkable first half of 2023 stands as a testament to the changing landscape for small-cap stocks and indicates that they may have finally found a foothold on the road to recovery.
Investors will need to keep a close watch on economic indicators and Fed policy actions as they navigate this rapidly evolving market terrain.
The Russell 2000 Index is a stock market index that represents the performance of the 2,000 smallest publicly traded companies in the U.S., providing a benchmark for small-cap investments.
In 2023, the resurgence of small-cap stocks can be attributed mainly to increased demand from the AI sector, alongside improved earnings forecasts and fundamental growth, contrasting years of underperformance.
While small-cap stocks offer growth potential, they also come with higher volatility and risks, particularly sensitive to economic changes and rising interest rates, which can impact their profitability.