Are small stocks about to take over? Wall Street has heard it before

Suddenly, smaller stocks seem to be making more noise on Wall Street.

After being trounced by their larger rivals for years, some of Wall Street's smaller stocks have shown much more vitality recently. Hopes for interest rate cuts have prompted investors to look at smaller stocks in a different light.

Smaller companies, which often carry large debt loads, may feel more relief from lower borrowing costs than large multinationals. Critics also said shares of big tech companies that had led the market for years looked expensive after their meteoric rises.

Small stocks in the Russell 2000 index rose an impressive 11.5% in five days, beginning July 11. The rise was even more striking compared with the tepid 1.6% gain by the S&P 500's large stocks over the same period. Investors pumped $9.9 billion into funds focused on U.S. small stocks last week, the most since 2007, according to Deutsche Bank strategists.

These were all encouraging signs for analysts, who say a market with plenty of rising stocks is healthier than one that relies on just a handful of star performers.

If all this sounds familiar, it should. Hopes for a market expansion have periodically been raised on Wall Street, including late last year. Each time, they have backfired and Big Tech has regained its dominance.

Of course, this time looks different in some ways. Part of the boost for small stocks may have come from rising expectations of a Republican landslide victory in November’s election, following President Joe Biden’s disastrous performance in last month’s debate. That pushed up U.S. stocks, which are seen as benefiting from a White House that could be hostile to international trade, among other things.

Traders are also thinking interest rate cuts are much more imminent than before, with recent expectations at 95% confidence that the Fed will make a decision as early as September, according to CME Group data.

But some professional investors are still not entirely convinced.

“Small-cap stocks need to be left out as this is probably not sustainable,” warns Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management.

He notes that 60% of companies in the small-cap index are struggling to achieve profitability, in part because private equity firms have already driven many of the profitable ones out of the stock market. Smaller-company stocks also tend to rely more on consumer spending than larger companies, and consumers at the lower end of the income spectrum are already feeling the strain of still-high prices.

Interest rate cuts appear more likely after Federal Reserve officials spoke about the danger of keeping rates too high for too long. But the Fed might not cut rates as quickly or as deeply as it has in past cycles if inflation stays high for longer, as some investors suspect.

Small stocks, which have struggled through five quarters of declining earnings due to higher rates, are also less likely to get a boost in earnings from the wave of artificial intelligence sweeping the economy, according to strategists at BlackRock Investment Institute.