Small-Cap Stocks Just Did Something They Haven't Done Since 2018. Is It Finally Time to Buy?

The Russell 2000 gained 2% during the week ended Oct. 23, ending six straight weekly declines. That was the small-cap index's longest losing streak since 2018. The rise also occurred during a week where the S&P 500 (SNPINDEX: ^GSPC) and the Nasdaq 100 both fell.

That split is curious because we've seen this pattern before in response to changes in long-term Treasury yields. It could be caused by a couple of factors.

One, small-caps tend to be more debt-heavy than large-caps and can experience a disproportionate benefit should rates fall. Two, we're starting to see investor concerns around artificial intelligence (AI) financing, net cash flows that are flipping negative, and rising credit risks.

This could be conditions swinging in favor of small-caps and the iShares Russell 2000 ETF (NYSEMKT: IWM) again.

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Tech spending triggers a flight to safety

After peaking at 5.36% in early October, the 10-year Treasury yield is back below 5%. Rates had been rising along with inflation, oil prices, and Fed expectations. But growing concerns about AI spending and the idea that some of the big tech names have overextended themselves have triggered a modest flight to safety that's brought yields back down.

That matters to small-caps that have borrowed significant sums to fund operations. Over the past two decades, State Street has found that small-caps have twice the sensitivity to Treasury yields as large-caps.

Valuation and earnings are the catalysts

One of the big things that has held small-caps back over the past few years has been a lack of earnings growth. Large-caps were doing great, but small-caps were offering little to no earnings improvement. That turned the group into laggards, leading them to trade at a significant discount to their large-cap peers.

Today, the earnings story has improved a lot. Small-cap earnings are expected to grow more than 20% year-over-year. But the Russell 2000 index still only trades at around 18 times earnings. That combination of fundamental improvement and valuation likely makes small-caps the better trade right now.

The risk that rates kill a small-cap rally

It's unlikely that the Fed will raise rates this week, but the futures market is still pricing in two or three more quarter-point hikes by mid-2027. With inflation and oil prices still high, the Iran war still raging, and soaring U.S. government debt, there's a strong case for why rates may need to move higher again to compensate.

If long-term yields reverse course, any small-cap rebound could fade quickly. From the end of June through early October, small-caps underperformed large-caps pretty consistently. This trend coincided almost perfectly with the 10-year Treasury yield climbing from 4.4% to 5.3%. Earnings growth could offset some of that headwind if they come through as expected. But it'll be tough to overcome if yields move higher again.

What I'd do with small caps right now

The iShares Russell 2000 ETF is about 9% below its all-time high in August. That makes it a reasonable buy-the-dip candidate but not a slam dunk.

I want to see small-caps follow through on their expectations for an earnings acceleration, but I really think it comes down to interest rates. If there continues to be a flight to safety trend, small-caps could outperform large-caps again (although it could very well mean falling less). Even if rates don't move favorably, the earnings narrative should be supportive of long-term upside.

For long-term investors, it might be a good time to consider diversifying into small-caps. The markets are growing more concerned that the spending cycle is peaking and that'll lead to a slowdown for AI stocks. Small-caps could be a natural fit given their improved earnings outlook and better relative value.

David Dierking 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.