America’s Smallest Stocks Are Staging a Comeback  <font color="#6f6f6f">The Wall Street Journal</font>

Shares of small U.S. companies are racing higher, stirring a debate among investors about how much longer the stock market can keep rallying despite some of the grimmest economic news since the Great Depression.

The market’s rally over the past several weeks has stood in contrast to the economic data investors have gotten since the coronavirus pandemic erupted. Friday’s Labor Department report showed the U.S. economy shed a record 20.5 million jobs in April. Analysts warn the pain will likely last longer, even as some states have moved to reopen businesses and lift stay-at-home orders.

None of that has stopped investors from putting money back into small-capitalization companies—a striking phenomenon, given their fate, more than multinationals’, is intertwined with the health of the domestic economy. In the coming days, investors will get a look at data including a reading of optimism among small businesses, retail sales and consumer confidence.

The rally has benefited companies such as defense contractor AeroVironment, which makes the Quantix drone.

Photo: David McNew/Getty Images

The Russell 2000 index, whose constituents have an average market cap of $2 billion, has risen 12% over the past month. That has far outpaced the S&P 500 and its 6.5% gain. The rally has benefited everything from language software provider Rosetta Stone Inc. (which has risen 21%) to defense contractor AeroVironment Inc. (up 11%) to Outback Steakhouse owner Bloomin’ Brands Inc. (up 46%). And the gains look even more notable considering how small-caps, which hit a peak in 2018, have lagged behind large-caps for much of the past decade.

Part of the resurgence appears to be driven by investors’ confidence that both the Federal Reserve and the government are willing to do whatever it takes to stabilize the U.S. economy. Interest rates are at rock bottom after a series of emergency rate cuts, and Congress has passed more than $3 trillion in aid to try to support consumers and businesses hit by an unprecedented loss of jobs.

The rally also appears to be driven by something simpler: bargain hunting.

As stocks plunged in March, Jason Pride, chief investment officer of private wealth at Glenmede, told his clients to consider picking up more stocks—especially shares of small companies. His thinking: Small-caps were among the hardest-hit groups at the peak of the selloff, with the rout taking their valuation down to around the 14th percentile of their long-term history. Small businesses are struggling with layoffs and making rent. But they might also have the most to gain when the economy recovers, Mr. Pride said.

Even with recent gains, the Russell 2000 index is down 20% for the year, compared with the S&P 500, which is off 9.3%.

“Every investor knows the second quarter will be horrible—that’s baked in already,” Mr. Pride said. “Markets today are reflecting a base case that encompasses us going back to a generally normal state at the start of next year.”

SHARE YOUR THOUGHTS

To what extent do you think the rebound tells us about investors’ faith in central bankers and government officials’ ability to help the domestic economy? Join the conversation below.

Brokerage BTIG has made a similar argument. The firm said it would be looking to buy small-caps on days when there is a broader market downturn.

Still, others are largely waiting out the market’s upswing. For every investor like Mr. Pride, it is easy to find counterparts who are worried that widespread expectations for economic activity to broadly recover in 2021 could be misguided.

For instance, businesses could reopen, and a second wave of infections could follow. Or what some investors have hoped are temporary job losses could wind up being more permanent.

“The market, when faced with enormous uncertainties, goes with the status quo—that we’ll eventually get back to where we were. But the question is if we’ll be in an environment where different types of companies are strong compared to the past,” said Lauren Goodwin, a multiasset portfolio strategist and economist at New York Life Investments, who described the market’s rally as a bit of a headfake.

Shares of companies such as Outback Steakhouse owner Bloomin’ Brands have raced higher.

Photo: Douglas R. Clifford/Tampa Bay Times/Zuma Press

The firm has kept the level of risk it has taken with its investments at relatively low levels, Ms. Goodwin said. For now, the fact that small-caps look relatively cheap isn’t necessarily enough to justify big bets on them, she added. That is especially true given they generally had weaker earnings and higher debt levels than large-caps even before the coronavirus pandemic, Ms. Goodwin said.

Even those who have taken advantage of lower stock prices to snap up bargains say they are wary of the risks of the unknown.

Mr. Pride acknowledges the trajectory of the economy will depend heavily on a key assumption: that as the U.S. economy reopens, there isn’t a second wave of coronavirus infections that forces another shutdown.

Such a move would likely hit small-caps especially hard, given he estimates the industries that have been most affected by the coronavirus outbreak—among them, restaurants and entertainment—account for millions of small businesses’ jobs.

“If there were to be a relapse—a second major wave—I’d guess markets may not continue to hang onto these levels,” he said.

Write to Akane Otani at akane.otani@wsj.com

Copyright ©2020 Dow Jones & Company, Inc. All Rights Reserved. 87990cbe856818d5eddac44c7b1cdeb8