Why investors have fallen in love with small American firms

Believe it or not, corporate America still makes room for the little guy. Around half of working Americans are employed by a firm with less than 500 workers. Nine in ten banks are community institutions that hold less than $10bn in assets. This rather parochial picture, however, is not reflected in the country’s stockmarket, where the falling number of public companies and extreme concentration of value are a concern. Among America’s 3,000 largest public firms, the biggest 1,000 account for 95% of total value. The next 2,000, which form the Russell 2000 index, are collectively worth less than Apple, the world’s most valuable company.

Now the unloved miniatures of America’s stockmarket are having their day in the sun. For most of the year, their shareholders watched the bull market from the stands: the Russell 2000 barely budged, while the S&P 500 index of large American firms rose by almost a fifth. Until the past week, that is, when the Russell 2000 was hurled forward as if by both of the market’s charging horns. The index has jumped by 9%, reaching its highest level since the beginning of 2022. Compared with the S&P 500, which is down slightly over the past week, its outperformance is the largest in history. Analysts are debating whether the move is a freak incident, the beginning of a “small-cap summer” or even a “great rotation” from big stocks to small ones.

It is never wise to entirely rule out freak one-offs, especially when it comes to moves of such magnitude. And there remains plenty that could go wrong for the tiddlers. Max Grinacoff at UBS says that there is “rampant” call option activity relating to the Russell 2000 index, which he sees as investors “renting upside” rather than going all in. There have also been previous false dawns. Before Christmas small caps rallied, fuelled by expectations of imminent interest-rate cuts, only for things to calm when it became clear cuts were a way off. Similarly, this time round, any data indicating that interest rates may be slower to return to Earth than investors now anticipate could quickly ruin the doveish mood.

That said, the case for America’s small caps has been growing for months. Compared with the achingly high valuations of the country’s biggest companies, the miniatures look like a rare and ever-more attractive bargain. Lori Calvasina of Royal Bank of Canada says that recent revisions to earnings estimates indicate the biggest American firms are no longer the sole object of analysts’ enthusiasm. On top of this, the two events that have dominated markets during the past week—an inflation surprise and an attempted presidential assassination—have both bolstered the case for buying small.

On July 11th data showed that American consumer-price inflation dropped to 3% in the year to June, coming in below expectations. Interest-rate cuts by the Federal Reserve, which typically benefit small stocks more than big ones, now look increasingly likely. Not only are the fortunes of the Russell 2000 more closely tied to the health of America’s domestic economy, lower interest rates would also provide their balance-sheets with welcome relief. According to Bank of America, around 40% of borrowing by firms in the index is taken on at a floating rate. A lower cost of capital, combined with attractive valuations, could also mean more Russell 2000 firms become takeover targets. Even if not all investors are fully convinced about owning small caps, private-equity firms desperate to strike deals and bigger companies looking for growth might be.

Two days later Donald Trump survived an assassination attempt at a rally in Pennsylvania, surely increasing his chances of winning re-election in November. Any investor yet to place their “Trump trade” is now scrambling to do so. For every one that sees fiscal indiscipline pushing up companies’ cost of capital and tariffs zapping profits, another predicts that corporate tax cuts and deregulation will boost the stockmarket. Investing in small firms appears to be a reasonable way to prepare for an administration that claims to be pro-business but despises the dominance of the largest technology firms. Indeed, the Russell 2000, with its domestic focus, could be a safe haven from Mr Trump’s blunders abroad, while benefiting from reshoring efforts and lower corporate tax at home. J.D. Vance, whom Mr Trump has selected as the Republican nominee for the vice-presidency, even once helped invest a venture-capital fund called “Rise of the Rest”. Small really could be beautiful for investors. ■

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