COLUMN-US small caps quietly notch historic outperformance vs tech: McGeever

By Jamie McGeever

ORLANDO, Florida, Aug 28 (Reuters) - Amid the Federal Reserve drama and deluge of corporate earnings in August, one clear but overlooked trend emerged in U.S. equities: the rotation out of expensive tech stocks and into cheaper small caps. As the month draws to a close, the big question is whether this can continue.

The Nasdaq 100 is currently on track for a monthly gain of 1.5% while the Russell 2000 small cap index is headed for a 7.3% rise, signaling an underperformance of 580 basis points for the tech-heavy index.

According to Stuart Kaiser, head of equity trading strategy at Citi, that relative monthly performance for the Nasdaq 100 is in the bottom 5% since 1985.

And if we look at ETFs, tech's underperformance looks even more striking. This month, the Invesco QQQ exchange-traded fund tracking the Nasdaq 100 is flat, while the iShares Russell 2000 ETF is up 7%.

FED BOOST

So what's responsible for this dramatic divergence?

It may partly just reflect investors seeking to rebalance their concentrated and lopsided portfolios. But the split was clearly turbo-charged by Federal Reserve Chair Jerome Powell's Jackson Hole speech on August 22, when he opened the door to an interest rate cut next month.

Manish Kabra, head of U.S. equity strategy at Societe Generale, says the Russell 2000 index's outperformance against the broader S&P 500 that day was the biggest since the U.S. election on November 6 last year that returned Donald Trump to the White House.

Powell's dovish pivot is helping small caps outperform because these companies tend to benefit more from lower interest rates given that they rely on borrowing to grow and expand. Larger firms, especially 'Big Tech' megacaps, often have huge cash reserves and easier access to other sources of financing.

To be sure, lower rates wouldn't just be good news for small caps. The rising tide of liquidity and investor sentiment would typically be expected to lift all boats, including the 'Magnificent Seven' megaships.

As analysts at UBS point out, past equity bubbles have often been burst by rising interest rates, so a resumption of the central bank's easing cycle would appear to minimize that particular risk for high-priced tech stocks.

But, regardless, small caps may still continue to get more of a Fed boost in the near term.

AI DOUBTS

Another catalyst for the rotation has been creeping doubts about AI's ability to deliver returns commensurate with the bubble-like frenzy surrounding the new technology.

Tech stocks remain on the pricey side. That's justified, argue UBS analysts, by the potential revenue from AI-generated efficiencies, which they estimate could reach around $1.5 trillion a year globally.

Others are less optimistic. If value creation on this massive scale fails to materialize, then tech companies will struggle to generate a return on the trillions of dollars of global capex expected in the coming years.

That's why all eyes were on $4.4 trillion Nvidia's earnings on Wednesday. How investors interpret the global AI leader's results will help determine whether tech's underperformance continues into September. The company's revenue, profit and forecasts looked solid, but uncertainty surrounding the suspension of its business with China and skepticism around the revenue outlook are giving investors pause.

UNDER THE RADAR

For now, market momentum remains with smaller firms. Francis Gannon, co-CIO and managing director at Royce Investment Partners, calls it a "stealth summer" for small caps, the recent outperformance of which has gone "mostly unnoticed" amid the daily headlines centered on economic uncertainty, geopolitical worries, and new highs in the larger cap-led indices.

Indeed, the Russell 2000 has yet to revisit last November's peak, while the Nasdaq and S&P 500 have been printing new highs for weeks.

Whether or not small caps start hitting new records will likely be determined by what happens at the Fed.

So the big macroeconomic events to watch next month will be the August employment report due on September 5, August CPI inflation data on September 11, and then, of course, the Fed's policy decision on September 17.

Small caps have enjoyed a pleasant end to the summer. Let's see what happens when investors all get back to their desks next month.

(The opinions expressed here are those of the author, a columnist for Reuters)