Yahoo Finance One of Wall Street's favorite trades is getting left behind in the stock market rally
Stocks are at a record high, but one of Wall Street's favorite trades for 2024 isn't participating.
After a Fed pivot began in November and sent investors pouring into interest rate-sensitive sectors to end the year, the recent push to new all-time highs in the market has been all about the tech sector (XLK), which is up nearly 5% to start the year, outpacing the S&P 500's (^GSPC) 2% gain.
Meanwhile, many of the stocks that rallied to end 2023 have lagged the benchmark averages, including the Russell 2000 (^RUT) small-cap index, which is down about 3% in January.
The index's sluggish start to 2024 raises the question of whether the good news that investors expect on interest rates later this year has already been priced in for small caps.
There's reason to think otherwise: A Bank of America survey conducted from Jan. 5-11 showed investors see large-cap companies underperforming small-cap companies in the next 12 months for the first time since June 2021. Meanwhile, the equity research team at Goldman Sachs says there's more room for small caps to run and sees a 15% upside for the Russell 2000 in the next 12 months.
"We expect a good economic backdrop in 2024. I think that is largely priced in," Goldman Sachs equity analyst Ben Snider told Yahoo Finance. "However, I do think there is substantial lingering risk premium embedded in parts of the market, including small caps, because investors are still unsure that we're moving away from this higher for longer interest rate environment. ... As the Fed begins to cut, we should see that risk premium decline. We should see valuations normalize to average levels, if not above average levels.
"And I think that is the reason why investors should be pretty optimistic about small caps."
The reason for the pullback on small caps so far this year stems from two key elements. For one, the rally to end 2023 wasn't just a rally. It was blistering hot: The Russell 2000 just posted its fastest recovery from 52-week lows to 52-week highs. And Wall Street strategists often point out it's not uncommon to see some form of a pullback after an impressive rally.
But aside from some expected profit-taking, the overall narrative on rate cuts has also come into question. Bets on a March interest rate cut soared after the December Fed meeting, reaching a near 90% chance a month ago. On Monday, bets on an interest rate cut are now below 42%, per the CME FedWatch Tool.
Read more: What the Fed rate-hike pause means for bank accounts, CDs, loans, and credit cards
And while the Fed narrative has shifted, so has the trading action. Just look at the broad averages hitting a record high on Friday while the Russell 2000 sits down about 7% off its December highs.
Wall Street strategists who like small caps in 2024 say the timing of Fed rate cuts matters little as long as they are indeed coming this year. This, combined with an outlook for economic growth this year, leaves the thesis to buy small caps unchanged.
Fundstrat head of research Tom Lee, a market bull whose highest conviction call this year is to buy small caps, believes small-cap equities will rally in the second half after the uncertainty about the timing of Fed cuts is settled.
Lee and Goldman Sachs' Snider also highlighted the record amount of cash on the sidelines. The Russell 2000 is still about 20% off its all-time highs in 2021, compared to the S&P 500 trading at its highest level ever. This means that when the investors holding cash look to move into stocks as interest rates come down and money market funds start yielding less, areas like small caps could look attractive, per Snider.
Read more: The best money market accounts for January 2024
"As the Fed begins to cut, we think there will be a rotation back out from cash into risk assets including equities and so ultimately, I'm thinking out six or 12 months ahead," Snider said. "I don't think it matters very much whether the Fed starts to cut in March or May or June. The key dynamic is that the Fed is incentivizing on-the-margin investors to move out of cash."
Both Snider and Goldman say this move will come as a top driver of small-cap performance — the health of the US economy — remains intact.
Recent readings have shown surprising strength in consumer spending, a rise in building permits, and a lack of widespread layoffs in the labor market. Goldman Sachs believes this trend will continue, and the US economy will grow above a 2% annualized rate in 2024.
"If I think about the market outlook for robust economic growth this year, that tells me that probably the market is also expecting a pretty robust earnings outlook for small cap companies," Snider said.
Josh Schafer is a reporter for Yahoo Finance.
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