The recent small-cap rally could persist but is tempered by fundamental concerns about profitability, earnings momentum, and debt levels, analysts at UBS caution.
The resurgence follows a period of underperformance relative to major indexes, driven by a cooling June CPI print and expectations of a favorable economic environment.
Analysts highlighted the similarities with previous market behaviors.
"We have seen this story before, most notably when the Fed 'pivot' in November to December 2023 drove similarly lofty price action," UBS wrote.
The rally is characterized by a rotation into small caps and increased call option activity, echoing patterns from late 2023.
The UBS team believes the rally could persist if several conditions are met. For the small-cap rally to be real and sustainable, UBS analysts believe there needs to be modestly sustained NFPs, continued economic growth, further CPI cooling, maintained rate cut expectations, a peaking of AI-related earnings, and strong investor reallocation towards small caps.
The analysts also emphasize the potential impact of curbing chip exports on megacap tech earnings, which could further support small-cap performance.
However, fundamental concerns remain. Over a third of small-cap companies remain unprofitable, and their earnings momentum has slowed.
“Despite these undesirable characteristics, we think there is room for the rotation into low quality to persist if rate cuts remain priced and the Trump 2.0 trade carries on ahead of US elections,” UBS analysts concluded.
“We would just want to see the boxes noted above checked off first, so to speak.”