by Esha Dey
Signs that US equities are overheating are cropping up everywhere, foreshadowing trouble for the nascent rebound in some of the riskiest stocks.
As the S&P 500 Index roared to a record high in the past month, shares of small-cap companies — which typically carry a higher debt load and are less profitable than their larger counterparts — surged even more. They handily outpaced bigger peers as investors shed their defensive stance and rushed into more speculative nooks. But history shows that when enthusiasm tips over into euphoria, it’s a bad omen for small caps.
A gauge of investor sentiment from Bloomberg Intelligence swung from panic mode in April to what BI calls “approaching manic” in June. BI strategists led by Gina Martin Adams found that once the meter hits manic, markets tend to cool off and smaller stocks start to trail larger ones. In the three months after manic readings between 2012 to 2023, the S&P 500 Index beat the Russell 2000, a small-cap benchmark, by 178 basis points, the strategists said.
It’s one more signal that bears watching as traders rush into speculative and volatile edges of the stock market, raising their bets on momentum-driven names despite substantial uncertainty around trade, the economy and geopolitics.
“Generally, small caps are viewed as pro-cyclical, and work in the early stages of a rally and outperform in good periods,” said Mark Hackett, chief market strategist at Nationwide. “And when the market drops, investors instinctively sell small caps.”
The most recent and stark example of this behavior came in the aftermath of the sharp risk-on rally that gripped the markets after President Donald Trump’s reelection. By late January BI’s gauge hit manic levels. In the three months that followed the S&P 500 fell 7.8%, while the Russell 2000 sank 14% as the new administration’s tariff regime unfolded and fears on the future of the artificial intelligence boom took hold.
Fast forward to July, both small- and large-cap stocks are proving resilient amid signs the US job market remains solid. On Thursday, the S&P 500 gained 0.8% and the Russell 2000 rose 1% after stronger-than-forecast employment growth soothed concerns about the US economy slowing.
Wall Street is watching small-caps as they are traditionally seen as a leading indicator, since they are historically the first to fall in times of economic turbulence and the first to emerge from a downturn.
On top of that, investors worried about the narrow leadership in stocks — with tech driving most of the gains in equities in the past few years — have also been keeping a close eye on small-caps to see if that strength can broaden out. A stock market that is bolstered by wider gains is seen as healthier and more able to withstand any sudden shocks.
After the Russell 2000 broke above its long-term trading range — the 200-day moving average — earlier this month, some are saying the group looks primed to climb further.
Dennis DeBusschere of 22V Research recommends staying long on small caps. He says the combination of slowing but stable economic growth, easier financial conditions and the tax and spending deal all point to economic growth in the first half of 2026, which is “positive for the riskiest or most economically sensitive stocks.”
Still, with key deadlines on tariff talks between the US and major partners days away and the state of the economy still in question, some strategists say stick with larger names with stronger balance sheets and higher earnings power.
Take Barclays strategist Venu Krishna. He still favors large-caps given the environment of weakening economic and survey data, despite the odds that Trump’s tax bill will boost the earnings of small-cap companies by double digits. He prefers bigger stocks for their improving earnings revisions, better margins, robust balance sheets, and greater leverage to macro growth drivers, such as AI.
“We do not think fundamentals argue for a sustained reallocation away from large-caps,” Krishna wrote in a note to clients last week.
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