Small Caps Flash Bullish Trifecta: Accelerating Earnings, Attractive Valuations, Impending Rate Cuts Signal Potential Rally

Small-cap stocks are flashing a compelling bullish signal, presenting a potential rally opportunity as earnings accelerate, valuations remain attractive, and the market anticipates significant interest rate cuts.

Are Small-Caps Ready To Challenge Mega-Cap Dominance?

This confluence of factors, highlighted by data compiled from LSEG Data & Analytics, Bloomberg, and Barclays Research and shared by X user @WallStJesus, suggests a fundamental shift that could challenge the long-standing dominance of mega-cap stocks.

Recent data paints a robust picture for the small-cap segment. Forward earnings growth for small-cap companies has seen a sharp acceleration, with “NTM (next 12 months) earnings growth” showing a significant upward trend, achieving 3.7% year-to-date.

This growth is projected to continue, with small-cap EPS growth expected to consistently outpace that of large caps (excluding technology) well into 2026.

Small-Caps Earnings Outperform In Q2

This outperformance was already evident in the second quarter, where small-cap earnings per share growth surged by an impressive 12.1% year-over-year, despite sales declining by 5.0%, underscoring strong operating leverage.

Moreover, the health of the small-cap universe is improving, with the share of unprofitable names declining from recent highs, indicating a flight to quality within the segment.

See Also: S&P 500 Is ‘More Concentrated Than Ever:’ Here’s What $100K In Its Top 10 Stocks Since 2021 Would Be Worth Today

Small-Caps Valuations Improve

Beyond the earnings story, small-cap valuations appear increasingly compelling. Despite recent gains, the premium for the Russell 2000 over the S&P 490 (excluding financials) in terms of EV/EBITDA stands at a modest 3.7%.

This figure is less than half of its 10-year median of 8.2%, suggesting that small caps are trading at a significant discount relative to their historical relationship with larger counterparts. This valuation gap offers a substantial margin of safety and potential upside as fundamentals improve.

Fed Rate Cuts Support Small-Cap Growth

Adding to the bullish outlook is a favorable macroeconomic environment, particularly the anticipated easing of monetary policy. Market participants are currently pricing in close to three cuts to the Fed Funds Rate by the end of 2025.

This dovish shift by the Federal Reserve is a critical catalyst for small-cap companies, which typically carry higher debt levels than their large-cap counterparts.

According to the data, the Net Debt/EBITDA for the Russell 2000 has consistently been higher than that of the S&P 500. Lower borrowing costs would directly reduce interest expenses, significantly boosting profitability and freeing up capital for investment and growth.

S&P 500 Is ‘More Concentrated Than Ever’

The S&P 500 has reached an unprecedented level of concentration, with the top 10 stocks driving 54% of its market cap gains since January 2021. — https://www.benzinga.com/etfs/broad-u-s-equity-etfs/25/07/46683483/sp-500-is-more-concentrated-than-ever-heres-what-100k-in-its-top-10-stocks-since-2021-would-be-worth-today

As the concept of “over concentration” in mega-cap technology stocks continues to percolate among investors, the improving fundamentals, attractive valuations, and impending tailwind from interest rate cuts position small-cap stocks as a potentially lucrative area for investment.

Price Action

The Russell 2000 index has gained 7.29% over the last month, 17.51% in the last six months, 6.56% year-to-date, and 13.03% over a year.

The SPDR S&P 500 ETF Trust SPY, Invesco QQQ Trust ETF QQQ, and iShares Russell 2000 ETF IWM, which track the S&P 500, Nasdaq 100, and Russell 200 indices, respectively, ended in a mixed manner on Wednesday.

The SPY was up 0.29% at $652.21, QQQ advanced 0.033% to $580.70, and IWM fell 0.18% to $236.43, according to Benzinga Pro data.

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Disclaimer: This content was partially produced with the help of AI tools and was reviewed and published by Benzinga editors.

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