Small cap stocks rallied this summer as Wall Street’s favorite🍸 tech names stumbled and investors looked forward to rate cuts from the Federa🌠l Reserve. The story has changed since the rate cuts arrived. 

The number of inquiries about small caps that Yusuf Abugideiri, chief investment officer at financial planning firm Yeske Buie, gets from clients has fallen since the summer. And inflows from retail investors into the Russell 2000 (as measured by inflows into single stock constituents of the index and their respective ETFs) rose after the rate cut, but have since slowed, according to Vanda Research Vice President of Data Science Lucas Mantle, falling below the record levels seen in July amid what was termed the “small cap rotation”.

Meanwhile, small caps have underperformed the S&P 500 since the day before the Fed’s announcement on Sept. 18—though only barely. The benchmark S&P has risen nearly 1%, while the Russell 2000 (RUT) has moved 0.5% lower.

Small Caps Come With Risks

Shares of smaller companies have cooled despite an environment some see as more favorable to them. Lower rates bring down borrowing costs, and smaller companies generally carry more debt than their lar๊ger counterparts.

Small caps are also considered more susceptible to economic fluctuations. The latest economic data–September’s j𒊎obs numbers came in stronger than expected, while inflation has moved closer to the Fed’s target–indicates a healthy U.S. economy, but some economists and investors are eying the possibility that a downturn could push investors toward the perceived safety of bigger companies’ shares. 

“Investors typically shun small caps when risk appetite is low and the economy is uncertain,” wrote Samantha Lau, A🐓llianceBernstein’s chief investment officer or small- and SMID-cap growth equities, in an email to Investopedia.

Lau believes that a recession-related small-cap crisis is unlikely. But BentOak Capital CEO Brandon Garrett doesn’t rule out the possibility of an economic downturn—which could end up disproportionately hurt👍ing small-cap companies. 

Russell 2000 companies’ earnings estimates for the second half of 2024 have been cut by nearly 20% in recent months, Bank of America analysts wrote last week, far more than those for larger Russell 1000 (RUI) companies.

“🌸Small caps are no longer cheap on an absolute basis, and any continued macro weakness p🔜oses risk,” the analysts wrote. 

Small Caps Still Lag the S&P 500

The Russell 2000 has risen roughly 9% since the start of this year, compared to a more than 20% increase for the S&P 500, which is influenced by large-cap tech stocks such as Nvidia (NVDA), Apple (AAPL) and Microsoft (MSFT).

In late September, Janus Henderson Portfolio Manager Jonathan Coleman said that small-caps may be due for a period of outperformance after years of relatively lackluster returns. But nearly half of them are unprofitable, according to BentOak's Garrett, meaning investors may have to be willing to undergo a bumpy ride. 

🌳 “The primary risk associated with small cap investing is higher volatility than large caps,” 🧜said Coleman. 

Meanwhile, a growing list of privately held, late-stage ventur🦄e-backed U.S. companies in recent years—coupled with a shrinking roster of public companies—may mean fewer quality small-cap options to begin with, notes𓂃 Zachary Evens, a manager research analyst for Morningstar. 

“Some of that excite꧑ment and potential that gets investors excited is now gone from the small-cap universe,” said Evens.