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Rotation to small cap stocks will be short-lived: Capital Economics
- The recent rise in small-cap stocks appears unsustainable, according to John Higgins of Capital Economics.
- Higgins said the fact that large-cap stocks are still near their all-time highs suggests no rotation has taken place.
- “We're not convinced” of a rotation from large-cap stocks to small-cap stocks, Higgins said.
The rapid and historic rise in small-cap stocks over the past week is unsustainable.
That's according to John Higgins, chief market economist at Capital Economics, in a note published Wednesday, which said the relative outperformance of small-cap stocks versus large-cap stocks is likely to be short-lived.
“The recent rise in the Russell 2000 following last week's June U.S. CPI report has sparked speculation that we are entering the early stages of a secular rotation into U.S. small-cap stocks. We are not convinced,” Higgins said.
First, Higgins said the recent market action should not be viewed as a rotation.
A rotation involves investors selling large-cap stocks and using the proceeds to buy small-cap stocks. But even though large caps have been sidelined from last week's rally, they're still just a few percentage points below their all-time highs.
“We would need to see more evidence of a selloff in ‘big tech’ to be convinced that a rotation into small-cap stocks away from their larger-cap counterparts is indeed underway,” Higgins said.
Higgins made the comments while acknowledging the sharp decline in large-cap technology stocks on Wednesday, sparked by comments from former President Donald Trump and the Biden administration considering restrictions on some semiconductor companies.
Much of the rally in small-cap stocks has been fueled by expectations that the Federal Reserve will cut interest rates soon.
But Higgins doesn't buy that argument either, noting that large-cap stocks outperformed their small-cap counterparts when the Fed cut interest rates in the mid-1990s, as well as when it cut interest rates in 2009 and 2019.
“We expect a stock market bubble to continue to form amid hype around AI, similar to the Internet hype in the second half of the 1990s. At that time, small-cap stocks generally underperformed their large-cap counterparts until mid-1999,” Higgins said.
Finally, Higgins stressed that the most important factor determining stock market performance is earnings, and there is no sign yet that small-cap stocks will outpace large-cap stocks in terms of earnings growth.
“It remains to be seen whether big tech companies in general will fail to continue to beat analysts' lofty earnings expectations,” Higgins said.
The first round of second-quarter results for major tech companies is expected to be released next week with reports from Tesla and Alphabet.
While Higgins isn't yet buying into the small-cap bull run, Fundstrat's Tom Lee does.
The strategist told clients Tuesday that he still sees small-cap stocks up 40% after they largely missed out on the broader stock market rally this year.
“Small caps are even more oversold and valuations, if you look at the average PE, which is now 10 times 2025 earnings, are even lower,” said Fundstrat’s Tom Lee. CNBC“So we think this evolution could last about 10 weeks and reach 40%. So I think this is just the beginning.”
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