Investor sentiment around small-cap companies is worse than it’s been in months. As it turns out, the mood isn’t much better inside their corporate boardrooms.
The small company-focused Russell 2000 is down roughly 10% from its late-2024 high as investors have lost faith in wagers that President Donald Trump’s policies would boost the sector.
Corporate executives are dour as well: An analysis of earnings transcripts by Bank of America Corp. going back to 2004 showed that sentiment on earnings calls of small-cap companies has never been as negative in comparison with their large-cap peers.
“The small-cap trade rallied on hope alone following the election, with a loose narrative that ‘pro business’ policies would particularly help smaller companies,” wrote Cameron Dawson, chief investment officer of Newedge Wealth. “However the harsh reality of higher-for-longer interest rates pressuring balance sheets, plus economic and policy uncertainty restraining earnings, has led to a reversal.”
The Russell 2000 was among a slew of so-called Trump trades that surged following the election, as investors bet that higher tariffs on foreign goods would boost demand for products from smaller, US-based companies.
So far, the reality is proving more nuanced, with several significant industry groups such as manufacturing potentially in the crossfire of a trade war. Tariff-vulnerable groups such as autos and components, capital goods and transports combined make up 15% of the Russell 2000, compared with 9.1% combined in the S&P 500, according to data from Bloomberg Intelligence’s Michael Casper.
Small caps are also bearing the brunt of nascent unease over the US economy, as investor concerns shift between the consequences of stubborn inflation and potentially weaker growth. Either outcome is arguably negative for the sector. Prolonged inflation could see the Federal Reserve leave rates elevated for longer, squeezing the margins of smaller companies, which are more often unprofitable and more sensitive to higher borrowing costs.
“With the Federal Reserve in a holding pattern, higher short-term rates are a negative for small caps given these companies tend to hold a greater proportion of short- and variable-rate debt,” wrote Keith Lerner, co-chief investment officer at Truist Advisory Services. He recently downgraded his view on small caps.
A growth slowdown would also be an unwelcome development for smaller companies, whose balance sheets are typically less resilient than those of larger peers. While fourth-quarter earnings for small caps were generally better than expected, the percentage of companies revising guidance lower jumped to the highest level since the first quarter of 2023, Bloomberg Intelligence data show.
That may be one reason why options investors appear to be positioning for more downside in the sector. Demand for options protecting against a 10% decline in the next month in the iShares Russell 2000 ETF (IWM) versus demand for options betting on a 10% gain has jumped to a level last seen in late December.
Of course, small caps have seen their share of sharp though fleeting turnarounds over the years, potentially putting bearish investors at risk. The Russell 2000 rallied nearly 8% in the week following the presidential election and spiked 5.4% after Trump’s standing in polls surged following an assassination attempt last summer.
Signs of US economic strength, ebbing inflation or improving chances for the Trump administration to push through tax cuts could all provide the basis for such a move.
Investors “remain at the two ends of the spectrum: afraid to miss out on a rally after a long period of underperformance, or conversely, worried about the ‘death of small caps,’” wrote BofA strategist Jill Carey Hall.
For now, however, the bears appear to be in charge. Technical indicators show that the Russell 2000’s recent decline has taken it below its 50-, 100- and 200-day moving averages. John Kolovos, chief technical strategist at Macro Risk Advisors, says the index now stands at an important inflection point.
“From a chart perspective, a sustained break down under the Jan. 13 low would imply an additional 10% downside risk,” he said.
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