Iran Tensions Are Heating Up Again. So Why Did the Russell 2000 Just Hit an All-Time High?

Last week closed with investors celebrating new all-time highs in the S&P 500 and the Nasdaq Composite after Iran said the Strait of Hormuz would reopen in response to news of a ceasefire between Israel and Lebanon.

Over the weekend, Iran closed the Strait of Hormuz after the U.S. refused to lift its blockade of the key waterway, which cooled off markets on Monday as all three major indexes closed lower, though they moved higher off a late-morning bottom.

The two-week ceasefire between the U.S. and Iran is also scheduled to end on Wednesday, and President Trump said he's unlikely to extend it, upping the stakes for ongoing negotiations.

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A surprising winner today

While the Nasdaq Composite had its first down day in 15 sessions and the S&P 500 fell for just the second time in three weeks, the Russell 2000 was a surprising winner today.

The small-cap index finished the session up 0.6% compared to a 0.2% decline for the S&P 500 and a 0.3% pullback for the Nasdaq.

The Russell 2000 tends to be more volatile than large-cap indexes and, therefore, more sensitive to breaking news, so it was odd to see the index move higher on a day when the news cycle seemed bearish, and stocks in general fell.

The small-cap index hit an all-time high on Monday, and a few factors could be pushing it higher.

First, expectations of an interest rate cut have risen as tensions in the Middle East have cooled. According to the CME Group's FedWatch Tool, there's a 35% chance of one rate cut by the end of the year. By contrast, a month ago, investors thought it was more likely that rates would go up, with a 25% chance of them rising. Small-cap stocks tend to be more sensitive to interest rates than large caps, so it makes sense that the Russell 2000 would outperform on improved rate-cut expectations.

Additionally, investors seem to be rotating from large caps into small caps. This movement has been expected for some time, and with the S&P 500 back at all-time highs, that may be triggering a shift into small caps, which are significantly cheaper. The largest Russell 2000 ETF, the iShares Russell 2000 ETF (NYSEMKT: IWM), trades at a price-to-earnings ratio of just 20, compared to the Vanguard S&P 500 ETF at 28.

Given that discrepancy, we're likely to see that rotation continue, and the Russell 2000 has beaten the S&P 500 this year. However, investors will likely need to see the situation in Iran move toward peace for that pattern to continue.

Jeremy Bowman has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.