This year began with heightened expectations amid market participants for multiple rate cuts by the Federal Reserve throughout the year. However, as inflation proved to be a genie that was tough to put back in the bottle, expectations for that long-awaited policy pivot started to decline.
While there's still hope for a rate cut this year, as the Fed has highlighted “good progress” on inflation, the central bank has now adjusted its messaging to indicate just one expected cut in 2024. As a result, many growth stocks have now given back the easy-money upside that investors were once pricing in for 2024.
However, some analysts are now becoming upbeat about small-cap stocks again amid upcoming rate cuts. One of those is UBS analyst Matthew Carter, who remarked in a recent note that “Small-caps are more reliant on floating-rate loans, so they stand to gain more from rate reductions from the Fed and the European Central Bank later this year.” The analyst also expects EPS growth for small-caps to outperform.
For broad exposure to the group, a small cap-focused exchange-traded fund (ETF) can be a smart choice for long-term investors. Here's a look at one of the best-known players in the space ahead of its annual reconstitution later this month.
About the IWM ETF
Launched in 2000 and hailing from the stable of BlackRock (BLK), the world's largest asset manager, the iShares Russell 2000 ETF (IWM) provides exposure to the performance of the U.S. small-cap stock market through a single investment. This allows for diversification and the potential for long-term growth.
IWM's benchmark is the Russell 2000 Index (RUT), and its assets under management (AUM) stand at a formidable $60 billion. That's not quite as big as BlackRock's other small-cap behemoth, the iShares Core S&P Small-Cap ETF (IJR), at $76B - but it places IWM ahead of the Vanguard Small-Cap ETF (VB) at $54B.
The IWM ETF has an expense ratio of 0.19%, and shares of the ETF are off 1.2% on a YTD basis. IWM also offers a dividend yield of 1.28%.
Currently, the top two holdings in the IWM are Super Micro Computer (SMCI), which recently graduated to the S&P 500 Index ($SPX), and Microstrategy (MSTR), which now carries a market cap of $26 billion after gaining over 400% in the last year. So, it's fair to say that this year's Russell rebalancing should be a fairly significant one for the top of the lineup.
The Rate-Cut Forecast Looks Favorable
Although downwardly revised expectations for a solitary rate cut in 2024 have dampened investor sentiments, forecasts are calling for four 25-bps rate cuts in 2025. Specifically, the Fed's Summary of Economic Projections expects the benchmark rate to dip to about 4.1% by the end of 2025 from its current range of 5.25% to 5.5%.
Against a backdrop of cooler borrowing costs, the case for small-cap stocks to move higher becomes stronger.
Small-Cap Stocks Look Cheap
Given the technical underperformance, small-cap stocks look cheap compared to their large-cap counterparts.
And according to Refinitiv's estimates, Russell 2000 Index earnings are expected to expand by approximately 20.7% this year, while the index currently trades at a forward price-to-earnings (P/E) ratio of 22.2x. In comparison, the broader S&P 500 Index is expected to achieve more modest earnings growth of 11.3% and trades at a 20.3x forward P/E ratio.
This data suggests that small-cap stocks, as represented by the Russell 2000, may offer relatively more attractive valuations and higher potential for earnings growth compared to their large-cap counterparts in the S&P 500.
Moreover, the IWM is on Barclays' list of ETFs with the most bullish sentiments, with a 31% rating.
How to Approach the Russell Reconstitution
Notably, Cboe's Rick Rosenthal says that the annual Russell index rebalancing tends to be a high volume event, but volatility around the benchmark update is typically “benign" - which creates an opportunity to harvest volatility premium, per the exchange operator's data.
For investors interested in adding shares of IWM, it may be a good time to brush up on the cash-secured put options strategy.
On the date of publication, Pathikrit Bose did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
