Lasting Recovery in Small Caps Still Elusive as Debt Costs Bite

The powerful rally in small-cap stocks looks like yet another false start rather than a lasting recovery.

The Russell 2000 Index — the world’s most closely followed gauge of smaller companies — rose over 5% last week as softer US inflation data bolstered bets that interest rates have topped out. Still, it will be hard for the gauge to avoid notching its worst year since 1998 against a benchmark of larger peers, given how vulnerable it is to damagingly high debt costs and a potential economic downturn.

What’s more, unlike its bigger counterpart, the Russell small-cap index has tried and failed three times in the past 18 months to sustain a rally into a bull market — defined as a 20% gain from the most recent trough.

All that is making investors fearful of calling a turning point, even though the small-cap index is hovering near the cheapest valuations since 2007 relative to the S&P 500 Index.

“You can rent the small-cap rally, but don’t own them yet,” said Manish Kabra, head of US equity strategy at Societe Generale SA. “The biggest issue is the upcoming refinancing cycle, as a quarter of firms have been loss-making in the last three years despite super-strong nominal GDP growth.”

US Small Caps Lag the SP 500 By Most Since 1998