By Jacob Sonenshine

Small-cap stocks have gotten hit big. They're back at levels where they often turn out to be clear buying opportunities.

The small-cap Russell 2000 index, the components of which have an average market cap of $4 billion, is down 10% since hitting a record high of $242 in late November, worse than the large-cap S&P 500 index's 4% fall from its high.

Driving small-caps lower has been the fact that markets are once again concerned that interest rates will stay high as the economy remains strong. The Federal Reserve cited inflation fears as the reason it's reluctant to cut rates more than once this year. The possibility of inflationary policies from the incoming Trump administration -- namely tariffs -- is adding fuel to the concerns.

The problem for small-caps is that higher rates will both dent economic demand and raise interest expenses. Floating-rate issues make up a higher proportion of smaller companies' debt, so when rates are higher, their cost of refinancing is higher, putting even more pressure on their earnings.

The good news is that much of the risk is already reflected in the stocks. The Russell 2000 trades at 23.7 times expected earnings over the coming 12 months. That's a mere 10% premium over the S&P 500's 21.3 times, versus 27.8 and a 24% premium in November. (The Russell historically tends to trade at a higher multiple.)

That's partly why buyers are stepping in to support the index at key levels -- just the signal a small-cap bull needs to see. The iShares Russell 2000 exchange-traded fund (ticker: IWM), at $217, has held strong above its 200-day moving average of $214.

It has remained above the 200-day moving average for 280 consecutive days, the longest stretch since late 2018, according to Dow Jones Market Data. When it has such a stretch, or a longer one, it has gone on to see a gain most of the time over the following 12 months of as much as 19%.

Rich Ross, Evercore ISI's head of technical analysis, recommends buying the Russell 2000 against what he calls "the most oversold conditions" since the Silicon Valley Bank crisis of 2023.

The Fed may or may not cut rates this year, but it isn't about to go on a rate-hiking spree, which means interest rates have already done much of the damage to small-cap stocks that they're going to do. Ross sees the 10-year Treasury bill, currently at 4.8%, as "range-bound." The last time it neared 5%, in late 2023, it promptly retreated.

Meanwhile, the economy can keep growing, even if it slows down a bit, and company earnings can keep pushing higher. Analysts expect aggregate sales for the Russell 2000 to rise just over 5% annually over the coming two years, according to FactSet. That would be enough to bring net profit margins higher, especially if interest expense stops rising, and it's partly why analysts are looking for 37% earnings growth annually in the index for the coming two years. That should take it higher.

The Russell 2000 has many money-losing biotech and technology companies. Investors who prefer to buy higher-quality companies should consider the Vanguard S&P Small-Cap 600 ETF $(VIOO)$, which owns only profitable companies. It trades very closely to the Russell 2000 and is down 9% from its high.

Either way, expect big things from the little guys.

Write to Jacob Sonenshine at jacob.sonenshine@barrons.com

This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.

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January 15, 2025 01:00 ET (06:00 GMT)

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