Large stocks celebrate record while small caps remain mired in bear market

Published Tue, Jan 23 20242:50 PM EST

Small caps are conspicuously absent from Wall Street's bull market party. The S & P 500 confirmed Friday that a new bull market has begun, breaking both its intraday and closing record high from January 2022. The Dow Jones Industrial Average followed suit on Monday with its own fresh record high. Year to date thus far, the S & P 500 is up more than 1%, while the Dow has climbed 0.5%. The recent leg higher was led by members of the so-called Magnificent 7 such as Nvidia, Meta Platforms and Microsoft. The Russell 2000 , however, is still in a bear market. The small cap index remains about 20% below its all-time high reached November 2021. According to Sundial Capital Research founder Jason Goepfert, this is the first time that the S & P 500 has reached an all-time high while the Russell 2000 remains in a bear market. .SPX .RUT 5Y mountain SPX vs RUT in past 5 years This divergence comes as traders hope other parts of the market participate in the bull run. However, small caps are contending with lackluster earnings — as well as a hyper focus on the Magnificent Seven stocks — which could keep the sector from fully capitalizing on the overall breakout. "The jump in 'Magnificent Seven' type stocks got a lot of attention last year, but the last month has been a standout. Nvidia accounted for 33% of the S & P 500's gains, while Microsoft accounted for 24%. So, 57% of the S & P's rise since mid-December was due to two stocks," Sundial's Goepfert said. "For the Russell 2000, in contrast, only one stock accounted for more than 5% of that index's gains (and just barely ... Super Micro Computer contributed 6%)." He added that a "shift in sentiment" is needed for the Russell 2000 to catch up. Some of the negative sentiment stems from investor concern over small caps' balance sheets in 2023 in light of the regional bank crisis, according to Jefferies analyst Steven DeSanctis. Wall Street worried that the event would cut off small-cap companies from financing and serve as a headwind. That argument may not hold water, DeSanctis added, because cash levels on small-cap balance sheets have been trending near record highs while debt-to-capital ratios have steadily declined. "Companies have figured it out," DeSanctis said. "They are fixing their balance sheet, but I don't think anyone is giving them credit for that." The analyst added that potential Federal Reserve interest rate cuts will serve as a positive catalyst for small-cap stocks moving forward despite the sluggish lag behind large caps. He thinks the prospect of rate cuts is a certainty at this point, and simply more a question of timing. "We think it's when the Fed cuts rates not if; this boosts small more than large," he wrote in a Monday note. Not everyone on Wall Street is as optimistic that Fed rate cuts will be an outsized catalyst for small caps. Barclays's Stefano Pascale noted the space has already been a large beneficiary of Wall Street rally on hopes of a Fed pivot at the end of 2023, which has in turn stoked volatility throughout small-cap trading. "[The Russell 2000] is the only Index where short-dated volatility is currently higher [now] vs at the beginning of the 'Fed pivot' rally, defying the more typical dynamic of negative spot/vol correlation," Pascale wrote in a Jan. 17 note. The Fed pivot refers to the moment last month when the Fed signaled it sees three rate cuts in 2024, up from two. Since then, the Russell 2000 is up more than 4% along with the S & P 500.