The recent dip in inflation as indicated by the Consumer Price Index (CPI) and a weaker than expected employment report point to a likely rate cut in September, a shift in market dynamics that could potentially favor smaller-cap stocks, which typically perform well during disinflationary periods. Institutional investors and traders could consider a strategic shift from large-cap to small-cap investment.

July CPI came in at 3% (year-over-year) while second quarter GDP growth clocked in at a robust 2.8%, signaling the potential for the Federal Reserve (Fed) to kick off its rate cuts in September. The FedWatch tool from CME Group  is reflecting a 86.5% probability of a quarter-point rate cut at the Fed meeting in September^[2].   

An easing of monetary policy represents an inflection point in the market for smaller-size companies as they have a higher sensitivity to interest rates than large caps. Smaller companies tend to rely on bank loans while corporations typically tap the bond market to raise funds.  Accommodative Fed policies could  lead to a sustained rally for smaller-size companies, which have already made gains as investors rotated out of large-cap stocks, especially AI related companies.  

Could small caps stage a successful rally against their large cap counterparts? The performance of small caps year-to-date as well as over a longer investment horizon, and the potential size rotation may provide insights.

Large-cap stocks have dominated equity markets  over the past decade.  Data shows that small caps have historically outperformed larger companies, particularly during periods of economic turbulence (1979 - 1983, 1990 - 1994, 1999 - 2014)^[3]. The performance figures reveal that while small caps can go through extended periods of underperformance relative to large caps, the reverse can happen for an extended period  as well.

Year to date^[4], small caps are underperforming large caps on an absolute basis (12.09% for S&P 500 versus 4.06% for Russell 2000). However, small caps did better than large caps in July due to interest rate expectations and repositioning^[5] (1.13% for S&P 500 versus 10.1% for Russell 2000).  CME Group witnessed significantly higher than average daily trading volume across the E-mini Russell 2000 Index futures and options in July.

A look at the upside and downside capture tells a nuanced performance story. Since January 1, 2024 the Russell 2000 index has outperformed the S&P 500 in 47.3% of the trading sessions with  average excess returns of 0.71%.

^{Source: CME Group. Data from 01/01/2024 - 08/2/2024 using daily price returns in USD.}

As more economic signs indicate that the Fed will likely lower rates, the case for investing in small caps grows stronger, and the recent Russell 2000 performance seems to support the rotation theory.

In large caps, size premium exists by tilting the portfolio away from market-cap weighting.  The S&P 500 Equal Weight Index has a tilt towards size factor due to the equal weighting mechanism.  During periods in which large mega-cap companies underperform, the index may not decline as much as the S&P 500, offering diversification opportunities within the large-cap segment itself.  For example, in 2022, S&P 500 declined -19.22% on price returns basis while the S&P 500 Equal Weight Index fell  - 13.11%.

We see this behavior in recent trading sessions such as that of July 24, when disappointing tech earnings dragged U.S. equity markets into the red.  While the S&P 500 declined -2.31%, the S&P 500 Equal Weight Index went down less at -1.22%. Exhibit 2 shows the performance spread between the indices during the last four weeks of trading sessions.

The long-term performance of the S&P 500 Equal Weight Index shows that alternative weighting mechanisms can potentially be sources of alpha, with the index outperforming the S&P 500 since its inception in Jan 1990 (see Exhibit 2) with slightly higher volatility^[6].  Research shows that the outperformance of the Equal Weight Index predominantly comes from alternative weighting which results in size, value and anti-momentum exposures^[7].    

Open interest (OI) in E-mini S&P 500 Equal Weight Index futures more than tripled to over 6K contracts in July as market participants look to diversify within their large cap allocations.

^{Source: CME Group.  Monthly price returns in USD from 01/31/1990 to 07/31/2024.}

With the macro data supporting the view that rate cuts are around the corner, equity markets are entering a highly volatile period with two more earnings seasons left for the year, along with a Presidential election in November. Rotation will become a key theme if small caps can shine in a low interest rate environment and mega-cap tech earnings continue to disappoint.  

CME Group offers a diverse equity product complex that allows investors to execute their investment objectives and achieve desired size rotation. 

With nearly 2.8 million contracts^[8] traded daily across the E-mini S&P 500 futures, Micro E-mini S&P 500 futures, E-mini S&P 500 Equal Weight futures, E-mini Russell 2000 futures, and Micro E-mini Russell 2000 futures, market participants have an opportunity to express views on small-cap return expectations and to diversify within the large-cap segment.

[1] Data as of 08/02/2024

[2] Data as of 08/05/2024

[3] Source:CME Group. Erik Noland, “Russell 2000 vs S&P 500: Compare Performance”.  https://www.cmegroup.com/education/featured-reports/equities-comparing-russell-2000-vs-sandp-500.html

[4] Data through 08/02/2024

[5] Goldman Portfolio Strategy, “Small Cap Rotation Triggered by Macro: Boosted by Positioning” July 22, 2024

[6] Data calculated using monthly price returns from Jan 31, 1990 through July 31, 2024

[7] See “Worth the Weight”, S&P Dow Jones Indices. July 2024

[8] Data based on averaging the daily volume traded from Jan 1, 2024 through Jul 31, 2024.

The S&P 500 is a broad-based, capitalization weighted index that tracks 500 of the leading companies in the U.S. and covers 80% of available market capitalization.

The S&P Equal Weight Index is the equal weight version of the S&P 500 and includes the same constituents as the market-capitalization-weighted S&P 500.  

The Russell 2000, widely used as a benchmark for small-cap stock performance, consists of the lower ~ 2,000 small cap stocks in the Russell 3000 Index.