Market sentiment "approaching euphoria" Small-cap stocks in the US show warning signs of rising
Signals from the U.S. stock market indicate overheating, particularly the rally in small-cap stocks may weaken. Although small-cap stocks have performed strongly over the past month, history shows that when market sentiment approaches euphoria, small-cap stocks often lag behind large-cap stocks. Research from Bloomberg Intelligence indicates that after sentiment indicators reach euphoric levels, the S&P 500 typically outperforms small-cap benchmarks. Investors should be cautious and pay attention to the future performance of small-cap stocks
According to Zhitong Finance APP, signals of overheating in the U.S. stock market are increasingly evident, suggesting that the recent upward momentum of some high-risk stocks may be coming to an end. Over the past month, the S&P 500 index has soared to a record high, with small-cap stocks performing even stronger. Small-cap companies typically have higher debt levels and lower profitability compared to large-cap companies. However, as investors abandon defensive positions and flock to more speculative areas, small-cap stocks have easily outperformed large-cap stocks. Yet history shows that when enthusiasm becomes excessively fervent, it is not a good sign for small-cap stocks.
An investor sentiment indicator from Bloomberg Intelligence shifted from a panic mode in April to "near euphoria" in June. The Bloomberg Intelligence strategist team, led by Gina Martin Adams, found that once this indicator reaches euphoric levels, the market often cools down, and small-cap stocks begin to lag behind large-cap stocks. The team noted that from 2012 to 2023, whenever the sentiment indicator reached euphoric levels, the S&P 500 index outperformed the small-cap benchmark Russell 2000 index by 178 basis points in the following three months.
Since the end of May, small-cap stocks have outperformed large-cap stocks.
Mark Hackett, Chief Market Strategist at Nationwide, stated, "Generally speaking, small-cap stocks are seen as cyclical stocks that perform well in the early stages of a market upturn and even better during favorable market conditions. When the market declines, investors instinctively sell small-cap stocks."
A recent prominent example occurred after U.S. President Donald Trump began his second term, with the market rising sharply due to a return of risk appetite. By the end of January, Bloomberg Intelligence's investor sentiment indicator reached extreme euphoria levels. In the following three months, the S&P 500 index fell by 7.8%, while the Russell 2000 index dropped by 14%, due to the gradual implementation of the new Trump administration's tariff policies and increasing concerns about the prospects of artificial intelligence.
By July, both large-cap and small-cap stocks showed resilience, as there were signs that the U.S. job market remained robust.
Focus on Small-Cap Stock Rebound
Wall Street is paying attention to small-cap stocks, as they have historically been viewed as important leading indicators, typically being the first to decline during economic turmoil and the first to recover after an economic downturn.
Investors are also closely monitoring whether the strength of small-cap stocks can further expand. A stock market supported by broader gains is considered healthier and more resilient to any sudden shocks.
Earlier this month, after the Russell 2000 index broke through its long-term trading range (i.e., the 200-day moving average), some believe the index is poised for further gains.
Dennis DeBusschere of 22V Research recommends holding long positions in small-cap stocks. He stated that the U.S. economy is slowing but stable, the financial environment is becoming more accommodative, and factors such as tax and spending agreements suggest that the economy will achieve growth in the first half of 2026, which "favors stocks that are the most risky or most sensitive to the economy." Countdown to Tariff Deadline
As the critical deadline for tariff negotiations between the United States and major trading partners approaches, and with ongoing uncertainty in the economic situation, some strategists suggest opting for larger companies with more robust balance sheets and stronger profitability.
Barclays strategist Venu Krishna stated that although Trump's tax plan could potentially lead to double-digit earnings growth for small-cap companies, he remains optimistic about large-cap stocks given the continued decline in economic and survey data. Earnings expectations for large-cap companies are improving, profit margins are higher, balance sheets are more robust, and they stand to benefit more from macro growth drivers such as artificial intelligence.
Krishna stated, "We believe that fundamental factors do not support a shift from large-cap to small-cap stocks."
