The frenzy of US small-cap stocks, is it just a short-lived short squeeze?

Recently, small-cap stocks in the United States have finally "turned the tables", with the expectation of a Fed rate cut heating up, funds flocking to the Russell 2000 Index, which surged by 12% in just 5 trading days. Although there has been some retracement in the past two days, the index's gain over the past week is still around 9%.

The iShares Russell 2000 ETF (IWM) emerged as the big winner, attracting $7.1 billion in fund inflows in the week ending Wednesday, according to Bloomberg data. In contrast, the Invesco QQQ Trust (QQQ) tracking the Nasdaq 100 Index attracted only about $2.7 billion during the same period. However, since 2024, IWM has seen $1.1 billion in outflows.

While investors are immersed in the frenzy of small-cap stocks, some analysts warn that this may just be a short squeeze rally, and even if the uptrend continues, following the index may not be the right investment approach.

Eric Johnston, Chief Equity and Macro Strategist at Cantor Fitzgerald, predicted in a recent report that small-cap stock returns this year are expected to be in line with 2021; part of the recent trend is due to short covering, which may not be sustainable; valuations are already at high levels, and short interest is also high.

Ed Yardeni, founder of Yardeni Research, emphasized the short squeeze nature of the recent uptrend in an interview with the media:

You will see biotech and banking, especially small regional banks, have seen significant increases, many of which may simply be short covering.

I don't know if their fundamentals have fundamentally changed, so I would be cautious about chasing mid-cap stocks and the Russell 2000.

Bank of America also holds a similar view, releasing a report on Thursday pointing out that short covering is a key factor driving the Russell 2000 higher, especially for stocks that were heavily shorted in the past performing the best.

Savita Subramanian, Head of U.S. Equity and Quantitative Strategy at Bank of America, highlighted in a mid-year outlook conference call that one-third of the companies in the Russell 2000 index are still unprofitable.

She noted that in small-cap stocks, high-quality stocks are more attractive, such as industrial and energy companies, sectors that may be more sensitive to GDP and consumer spending are also attractive, while companies with more refinancing risks or more sensitive to interest rates are still under observation until the Fed actually starts cutting rates Indeed, in the trading sessions on Wednesday and Thursday, small-cap stocks trading seemed to lose momentum, but looking at many other small-cap stock funds outside of the IWM ETF, there is still a lot of optimism in the market