Small-Cap Rally Signals Further Market Gains

When the Russell 2000 index of small-cap stocks hits a new all-time high, it is generally considered a positive and expansive sign for the broader market and the economy. As of last Thursday, the Russell did just that, closing at record high of 2,467.70 signaling a fresh level of “risk on” sentiment.

Historically, a new all-time high in the Russell 2000, particularly one that breaks a long period of underperformance relative to large-cap stocks, has often been a precursor to further gains in the major indexes like the S&P 500 over the following 12 months. It is often viewed as the final piece of the puzzle confirming a sustained bull market.

This is a very special development for market bulls. For much of the past two years, large-cap indexes, like the S&P 500 or Nasdaq, have rallied to new highs led by a few massive tech companies. The Russell trading to a new high suggests the rally is broadening out to smaller, more diverse companies, confirming the strength of the bull market across different segments of the economy.

This sudden rally by the Russell is a paradox of sorts in that a lot of recent economic data points to slowing economic growth. The Bureau of Labor Statistics revised its payroll data downward by 1.2 million jobs for the 16 months leading up to March 2025. This suggests job growth was significantly weaker than previously believed.

“The U.S. economy barely has any jobs right now and it’s been that way for a long time,” said Heather Long, now the chief economist at Navy Federal Credit Union and prior to that a Fed reporter for the Washington Post. “The Federal Reserve needs to cut interest rates in September, October and December, and the White House needs to quickly finalize a trade deal with China. Businesses aren’t going to invest and hire more people again until there is more certainty.”

The paradox of the Russell 2000 hitting new highs while the labor market is softening comes down to one key factor: investor expectations for Federal Reserve policy. The market, especially the interest rate-sensitive small-cap sector, is betting on a “bad news is good news” scenario. Small companies are highly sensitive to interest rates because they tend to carry more debt, often with floating rates, and rely more heavily on external financing for growth.

Hence, the lower cost of capital has an immediate positive impact on profit margins, making their future growth prospects more valuable. That is a catalyst for higher stock prices. It also assumes that hiring will pick back up because the Fed’s dual mandate of price stability and maximum employment will now tilt more toward supporting job growth. This view of the Fed being more aggressive on future rate cuts to stimulate employment growth is fueling bullish sentiment for small caps.

Below are the top 10 holdings for the iShares Russell 2000 ETF (IWM):

Within the top holdings in IWM, there are no financials even though they comprise the largest weighting in the Russell 2000. Knowing this, as the Fed lowers rates and lending and refinancing volumes increase, the smaller regional and community banks will very likely see their stock prices pick up speed to the upside, further boosting the potential gains for the Russell.

Source: www.yahoofinance.com

The bearish camp takes the position that this is a head fake rally. If rate cuts fail to stimulate real job growth or earnings disappoint, small caps could retrace a good portion of the recent gains. There is a growing view that AI is rapidly replacing jobs. That idea has strong merit. Just because the Fed lowers the cost of borrowing doesn’t guarantee job growth — not at all. AI has become the greatest eliminator of jobs since Covid.

A recent Stanford University study found a 13% decline in employment for U.S. workers aged 22-25 in occupations most exposed to AI, such as customer service, accounting and software development (https://digitaleconomy.stanford.edu/). J.P. Morgan analysis shows unemployment among college graduates — especially in majors like computer engineering and design — has risen to 5.8%, the highest in over four years. This suggests AI is already displacing knowledge workers.

The Bureau of Labor Statistics now incorporates AI’s impact into its employment forecasts, noting that while displacement tends to be gradual, the scale and speed of generative AI adoption are unprecedented. Unlike past tech shifts, generative AI tools like ChatGPT scaled to millions of users in months, not years. Unlike COVID, which devastated service and manual labor sectors, AI is targeting white-collar, cognitive jobs which is a new development in labor disruption.

What is at work is a new set of market conditions: a possible rising trend in unemployment among higher-paid workers and a rising stock market led by the productivity and efficiency gains brought about by the implementation of artificial intelligence that generates higher corporate profits. Consumer sentiment is not just psychological, it is predictive. When people fear job loss, they delay major purchases, cut discretionary spending and increase savings rates, which slows velocity of money.

The old saying of “enjoy the ride” as the bullish sentiment has spilled over to the small caps, thereby broadening the rally. But as a consumer-driven economy, AI brings uncertainty to numerous occupations that were once considered secure. Investors are well aware of this dichotomy between market optimism and labor market fragility, or between AI-driven productivity and human displacement. And at some point, it will matter to Mr. Market. But for now, the Russell 2000 is celebrating future rate cuts.