The Russell 2000 index rose as much as 12% in just five days, reaching a new high at the end of 2021. After three years, American small-cap stocks finally had a chance to shine through this round of gains.

Maxwell Grinacoff and other UBS analysts released a research report on Thursday, pointing out that the recent recovery of small-cap stocks is closely related to the Fed's policy shift and the market rotation driven by the US election. The cooling of June's CPI data, the market's increased expectations for the economic environment, and the restart of Trump's trade all provided impetus for the rebound of small-cap stocks. However, is this recovery sustainable? UBS believes that the rotation of the US stock market to small caps may continue, but the premise is that the profit growth of large technology stocks slows down. The recent plummet of semiconductor stocks supports the view of rotation. The institution writes that although momentum trading has begun to decline, there is no evidence of a complete collapse of momentum trading. Despite the recent strong performance, UBS pointed out that small-cap stocks still lack strong support in terms of fundamentals: Currently, more than one-third of the Russell 2000 constituent companies still have no profits. Compared with the S&P 500 index, the earnings forecast of the Russell 2000 index has significantly slowed down in recent quarters. The stock risk premium of the Russell 2000 index is close to a historical low, indicating that investors have a low evaluation of its risk. The leverage ratio of the Russell 2000 index is high, and its ability to repay debt has declined. More than 45% of the Russell 2000 constituent companies' total debt consists of floating-rate notes, which may bring unexpected gains when interest rates fall, but also increase the risk when interest rates rise. This view is consistent with the general expectation on Wall Street. Due to the lack of substantive fundamental support, there is a certain risk of a bubble in small-cap stocks. Some analysts are worried that once market sentiment reverses, it may trigger a sharp correction.

However, will this recovery be sustainable? UBS believes that the rotation of the US stock market to small caps may continue, but the premise is that the profit growth of large technology stocks slows down. The recent plummet of semiconductor stocks supports the view of rotation. The institution writes that although momentum trading has begun to decline, there is no evidence of a complete collapse of momentum trading.

Although momentum trading has begun to decline, there is no evidence of a complete collapse of momentum trading.

The fundamentals are not optimistic.

Despite the recent strong performance, UBS pointed out that small-cap stocks still lack strong support in terms of fundamentals:

Currently, more than one-third of the Russell 2000 constituent companies still have no profits.

Compared with the S&P 500 index, the earnings forecast of the Russell 2000 index has significantly slowed down in recent quarters.

The stock risk premium of the Russell 2000 index is close to a historical low, indicating that investors have a low evaluation of its risk.

The leverage ratio of the Russell 2000 index is high, and its ability to repay debt has declined.

More than 45% of the Russell 2000 constituent companies' total debt consists of floating-rate notes, which may bring unexpected gains when interest rates fall, but also increase the risk when interest rates rise.

This view is consistent with the general expectation on Wall Street. Due to the lack of substantive fundamental support, there is a certain risk of a bubble in small-cap stocks. Some analysts are worried that once market sentiment reverses, it may trigger a sharp correction.

Several key observation points

Looking ahead, UBS has put forward several key observation points that may affect the trend of small-cap stocks:

Non-farm payrolls: The moderate growth of non-farm employment in the coming months is the key to whether the recovery of small-cap stocks can continue.

Economic growth: The stability of economic growth is crucial to the performance of small-cap stocks.

Process of lowering inflation: Although there are expectations, the trend of cooling CPI needs to continue.

Expectations for interest rates: The market's expectations for interest rate cuts need to remain stable to avoid concerns about "higher and longer".

Profit tailwind related to AI: The development of AI technology has a significant impact on the profitability of small-cap stocks.

Investor's capital reconfiguration: Whether investors are willing to reconfigure capital into small-cap stocks is the key to their long-term performance.

In addition, small-cap stocks have a key issue: the ability of small-cap stocks to benefit from factors such as interest rate cuts has weakened. Dennis DeBusschere of 22V Research previously stated:

The rate cut from the soft landing has reached its maximum. When there is a hard landing, the rate cuts will be greater.

The performance of small-cap stocks in the past five days has set the largest increase in history, and they may have digested all the good news. This means that from now on, the speed of return should slow down.

How to hedge against small-cap stock risks?

UBS Group's strategy team believes that potential gains from small-cap stock appreciation can be obtained by purchasing call options on iShares Russell 2000 ETF (IWM) without directly buying these stocks.

Although call options are very active, IWM call options are still relatively cheap in the current market environment.

Wall Street News previously mentioned that currently small-cap stocks in the US are still "cheap", with Bloomberg data showing that the P/S ratio of small-cap stocks to the S&P 500 index is close to the lowest level in 20 years.

In addition, UBS also pointed out that the reissue of structured financial products, especially financial notes related to the Russell 2000 index, may increase the volatility of the index and drive it further up.