These 2 key metrics will signal whether small, unloved stocks will continue to beat the market

Small-cap stocks have enjoyed their day in the sun lately after years of underperformance. But can it last? New research from Bank of America outlined two specific criteria that could serve as signals the rally will continue.

According to the bank, the 10-year US Treasury yield must remain below 4%, while the ISM purchasing managers’ index must rise above 50.

Past instances when both signals have flashed resulted in outperformance by the equal-weighted S&P 500 (SPW), relative to the market-cap-weighted version of the index that’s more susceptible to the pull of mega-cap tech (SPX). The SPW is considered a good reflection of small-cap strength.

“Historically, when the 10-yr yield fell by more than 1ppt from its 12-mo. peak (would be 3.99% today) and the ISM PMI rose over 4 points from the lows (would be 50.5 today), SPW outperformed SPX 90% of the time by 6.3ppt on avg,” BofA analysts wrote, citing the chart below.

Small-caps gained momentum after June’s unexpectedly cool inflation print, which amplified market certainty about an upcoming interest rate cut. Investors now indicate 93.6% odds that the Federal Reserve will start easing policy in September.

With that in mind, investors have grown more eager to embrace sectors expected to benefit from lower borrowing costs. Included names are typically more exposed to leverage and could surge in the coming months.

The small-cap-focused Russell 2000 has already shown signs of life, soaring more than 12% in July before pairing gains. To BofA, its recent highs mark the largest move outside of March 2020.

For most of this year, high rates and a frenzy for large-cap tech trades kept the Russell’s momentum restrained. But with investors now snapping up the overlooked index, some consider it proof of a broad market rotation.

“I think that August is really going to be one where the rotation becomes more evident, and I think it’s going to be stronger small-caps and maybe flat, just slightly down for the S&P,” Fundstrat’s Tom Lee said last week, projecting 40% upside on the Russell.

Others are not so sure.

Despite expectations, Barclays found that small-caps don’t typically outperform the S&P 500 after the first interest rate cut. In fact, the Russell tends to decline, analysts said.

Currently, neither of BofA’s criteria has been met to support a longer rally. Although the 10-year rate has progressively slid since peaking in May, it remains above 4%.

Meanwhile, manufacturing PMI fell to 48.5 in June.

“The Manufacturing economy is in the second longest downturn in history with 21 months without two straight months of 50+ PMI. We believe a large part of that has been caused by the de-stocking cycle, which we expect will be moderating in 2H,” bank analysts wrote.