Bank of America has outlined two specific criteria for the ongoing small-cap-stock rally to continue: the 10-year US Treasury yield and the ISM Purchasing Managers’ Index (PMI). According to the bank’s analysts, the 10-year Treasury yield must stay below 4%, and the ISM PMI must rise above 50. Historical data supports this correlation; when the 10-year yield drops by more than one percentage point from its 12-month peak (which would be 3.99% today), and the ISM PMI increases by over four points from its low (which would be 50.5 today), small-cap stocks have outperformed larger stocks 90% of the time by an average of 6.3 percentage points.
Bank of America equity and quant strategist Jill Carey Hall is optimistic about the prospects for small-cap stocks this year. She notes that small- and mid-cap stocks tend to outperform during election years and periods when the Federal Reserve cuts interest rates. The Fed is expected to make its first rate cut in March 2024, which historically has been a favorable condition for small-cap stocks. Carey Hall emphasizes that small caps have typically outperformed one, three, six, and twelve months following the first rate cut, particularly during the high inflation periods of the 1970s and early 1980s when the Fed implemented similar rate hikes.
In her analysis, Carey Hall highlights the value potential in small- and mid-cap stocks, especially considering their relative undervaluation compared to growth stocks. Even though the Russell 2000 Growth Index outperformed the Value Index last year, value-oriented small-cap stocks showed significant strength, particularly those with high free cash flow yields and strong EBITDA/EV ratios. Carey Hall points out that value stocks within the small-cap segment remain attractively priced and are expected to benefit from favorable economic conditions this year, including fewer low-quality stocks with no earnings.
To identify the small-cap stocks most likely to outperform this earnings season, Carey Hall screened for small- and mid-cap stocks that Bank of America analysts believe could exceed consensus earnings estimates. She looked for companies that beat both earnings per share (EPS) and revenue expectations in the previous quarter and are currently rated as buys by Bank of America. The result is a list of 17 small- and mid-cap stocks that have strong potential to deliver positive earnings surprises.
Despite this positive outlook, Wall Street remains divided on the sustainability of the small-cap rally. While some experts believe the rotation into small-cap stocks will continue, others are more cautious. For example, Barclays analysts argue that small-caps typically do not outperform the S&P 500 after the first interest rate cut. In fact, the Russell 2000 Index, which focuses on small-cap stocks, tends to decline in such scenarios.
As of now, neither of Bank of America’s criteria for a sustained rally has been met. Although the 10-year Treasury yield has been declining since its peak in May, it remains above 4%. Meanwhile, the manufacturing PMI fell to 48.5 in June, indicating a contraction in the manufacturing sector. Bank of America’s analysts note that the manufacturing economy is in its second-longest downturn in history, with 21 months without two consecutive months of PMI above 50. They believe this downturn is largely due to a de-stocking cycle, which they expect to moderate in the second half of the year.
In summary, while the potential for a sustained small-cap-stock rally exists, it hinges on critical economic indicators such as the 10-year Treasury yield and the ISM PMI. Investors will need to monitor these indicators closely, along with the broader economic environment and Federal Reserve actions, to gauge the prospects for small-cap stocks in the coming months.