August 2025 - Market Recap (The rise of small cap stocks?)
Summary:
August saw positive returns across the board for both equites and fixed income. The most notable move in the markets was the performance of small-cap stocks which surged over 7%, a significant shift from the concentrated leadership of mega-cap technology stocks that have dominated markets throughout 2023 and 2024.
3 Reasons why small cap stocks rallied?
1. Growing expectation of Federal Reserve interest rate cuts.
Fed Chair Powell's dovish comments at the Jackson Hole symposium in late August signaled the central bank's inclination toward easing monetary policy. This development is particularly important for small cap companies because they typically carry higher debt loads and maintain a greater proportion of variable-rate debt compared to their larger counterparts. When interest rates decline, the cost of borrowing falls more dramatically for these smaller companies, directly improving their profit margins and financial flexibility.
2. Undervalued after years of underperformance
Beyond the interest rate environment, small cap stocks had become significantly undervalued after years of underperformance. Small cap stocks were trading at a 15% discount to fair value, while large and mid-cap stocks were fairly valued. This created a compelling value proposition that attracted investors seeking opportunities beyond the expensive mega-cap growth stocks that had driven market gains previously.
3. Shift in investor sentiment toward more fundamentally driven valuations.
After years of being overshadowed by the "Magnificent Seven" technology giants, the strong performance of small caps signaled a healthy broadening of market leadership. This diversification away from concentrated mega-cap dominance suggested that investors were becoming more willing to explore overlooked segments of the market that are generally more sensitive to domestic economic conditions, benefit more directly from an improving business environment and offer attractive risk-adjusted returns.
Can the small cap rally continue?
Whether the small cap rally can continue will depend on what happens with the economy and interest rates. As noted above, August returns can in part be attributed to Fed Chair Powell's comments in Jackson Hole signaling the likelihood of cuts to the Fed Funds rate in September which would lower the borrowing cost for business operations and consumers. In his comments Powell said, "the shifting balance of risks may warrant adjusting our policy stance". The "risks" he is referring to is an increased concern about the economy slowing vs. concerns about inflation.
Bear Case
Concerns about the economy are largely born out of recent employment data showing a downward trend. The BLS employment report in August showed an increase of only 73,000 jobs in July and included a downward revision of 258,000 jobs from the previously reported May and June figures (see below). The more salacious story, reported throughout the media was President Trump's reaction to the announcement which resulted in the firing of the head of the BLS, but it does not change the trend.
Adding to the Fed's concern about the economy is the potential impact tariffs may have on consumers. A Goldman Sach's report released in early August suggests that thus far two-thirds of the increased costs from tariffs have been absorbed by US businesses, but they expect that percentage to flip to consumers by October.
Bull Case
The bull case for small caps is that they are still attractively valued relative to larger US stocks, they should benefit from de-regulation, and stimulus from the tax bill could provide support to the consumer and the overall economy. The sweet spot for small caps would be at least a couple Fed rate cuts and no meaningful deterioration to the overall economy. So, the ideal scenario for small caps is that: 1) inflation remains stable - freeing up the Fed to cut rates 2) economic growth remains in check 3) the Fed cuts rates.
In August, we got the indication that rate cuts are likely on their way in September and the Philadelphia Fed released their Third Quarter Survey of Professional Forecasters which boosted expectations for economic growth (GDP) in the near-term.
Conclusion
US small cap stocks rode the wave of investor's desire to expand outside of the mega-cap tech stocks, the ability to continue the ride will depend on economic data that will come in the next two months. If the economy holds strong, then small caps may be able to continue their ride.