BofA, UBS see small-cap outperformance as Powell turns dovish

Small caps were already riding the wave of a recent rotation out of Big Tech and into lagging parts of the market. Then came dovish remarks from Federal Reserve Chair on Friday, which likely provided more room to the rebound.

Such is the view of strategists at Bank of America Corp. and UBS Group AG, who cited optimism over Jerome Powell’s Jackson Hole remarks that signaled an interest-rate cut is coming as soon as next month. “In the absence of major tariff news or other macro surprises, we think the Russell 2000 likely leads large caps in the coming weeks,” BofA equity strategist Jill Carey Hall wrote in a note to clients Monday. 

The sentiment is echoed at UBS AG, where strategists including Sean Simonds say small caps and low-quality stocks “could continue to outperform as rate cuts help alleviate balance sheet pressures.” The Russell 2000 Index jumped 9% in the three weeks through Friday, compared with a 3.2% gain in the Nasdaq 100 Index during that time. 

The UBS strategists pointed to a surge in earnings revisions for Russell 2000 companies since bottoming out in early May, tracking a rally for the index. The sector has trailed the broader stock market for months, and hasn’t posted a record since November 2021.

The Russell 2000 jumped 3.9% Friday in its best day since early April after dovish comments by Powell convinced traders that rate cuts are all but guaranteed. Investors responded accordingly, injecting the most cash into the iShares Russell 2000 ETF since November. The benchmark small-cap gauge clocked its best week since July 2024 relative to the Nasdaq 100 before losing 0.4% on Monday. 

“Small caps finally broke out after Jackson Hole,” Lori Calvasina, RBC Capital Markets’ head of US equity strategy, wrote in a note to clients, pointing to Powell’s speech at the meeting. The sector may be poised for near-term gains, driven in part by investor positioning and some rotation away from the biggest tech companies, she said.

However, Calvasina said she is staying neutral longer term, relative to large caps. “Small caps run the risk of seeing only a short-lived outperformance trade once again, particularly if the economic concerns that appeared open the door for a September cut ultimately come to fruition,” she wrote.

BofA’s Hall said she is watching next week’s jobs report for support for a September cut — beyond that, a persistent rally for the sector will depend on earnings, sales trends and tariff risks. Hall cautioned that October has historically been the worst month for small-cap performance versus large caps.

Keith Lerner, co-chief investment officer at Truist Financial Corp., on Friday upgraded US small-cap stocks to neutral from “less attractive,” citing valuations, improved earnings trends and technical signals that are turning more constructive.

Still, the S&P Small Cap 600 is trailing large caps by 12% over the past year. On a three-year rolling basis, the underperformance is near the most extreme since 2000, Lerner said, offering investors a “catch-up opportunity.”

But, the difference between estimated and actual earnings growth for small caps is topping 12% so far this quarter, the widest spread since the first quarter of 2022, Jefferies Financial Group Inc. strategist Steven DeSanctis wrote earlier this month.

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