Small-cap stocks enjoy best first half since 1991 as AI trade expands

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Small-cap U.S. stocks have experienced a remarkable first half of the year, marking one of their strongest performances in decades. This surge is not just a typical small-cap boom driven by traditional businesses tied to the economic cycle. Instead, it has been fueled by the rapid expansion of AI infrastructure, with investment spreading beyond the major tech companies to a wider network of suppliers.

Investors are optimistic that the rally in small stocks can extend beyond the tech sector as long as interest rates remain stable. The Russell 2000 Index has soared more than 21% year-to-date, on pace for its best first-half performance since 1991. This turnaround comes after years of small-cap stocks underperforming their larger counterparts.

Amy Zhang, a portfolio manager at Alger, attributes the rally to both valuation catch-up and improving fundamentals. The valuation gap between small-cap and large-cap stocks was substantial, creating opportunities for growth. Additionally, companies in the semiconductor and semiconductor-equipment sectors have been major beneficiaries of the AI investment boom. Chip-related firms, including Aehr Test Systems, Ichor Holdings, and MaxLinear, have seen their stocks surge by over 400%.

Rather than directly competing with industry giants like Nvidia, smaller companies in the AI supply chain are reaping the rewards of increased demand. As tech companies and cloud providers ramp up their AI infrastructure spending, suppliers of semiconductor equipment and components are experiencing significant growth. This trend is amplifying revenue and earnings for smaller companies with lower market capitalizations.

While AI has played a pivotal role in the small-cap rally, experts believe that other fundamental factors are also supporting the rebound. Small caps have shown resilience amid the dominance of mega-cap stocks, with a focus on semiconductors and technology hardware. Strong fundamentals and growing optimism about profit growth beyond tech giants have contributed to the positive outlook for small-cap stocks.

Looking ahead, catalysts like increased exposure to the U.S. economy, expectations of heightened merger-and-acquisition activity in the pharmaceutical and biotech sectors, and tax incentives for capital investment could sustain the momentum for small-cap stocks.

However, the main threat to the rally remains higher interest rates. The possibility of rate hikes by the Federal Reserve could pose challenges for smaller companies with more floating-rate debt and refinancing needs. Despite this, many investors believe that the worst of the tightening cycle is behind us, with expectations that inflation and rates may have peaked.

In conclusion, the small-cap rally driven by AI infrastructure investment is expected to continue, supported by a mix of fundamental factors and positive market dynamics. As long as interest rates remain stable, small-cap stocks could see further growth and opportunities for investors.