Why the stock market's rotation into small-caps will be short-lived

"We are not convinced" of a rotation from large-cap stocks to small-cap stocks, Capital Economics said.

• The recent surge in small-cap stocks appears unsustainable, according to Capital Economics' John Higgins.
• Higgins said the fact that large-cap stocks are still near record highs suggests no rotation has taken place.
• "We are not convinced" of a rotation from large-cap stocks to small-cap stocks, Higgins said.

The rapid and historic rally in small-cap stocks over the past week is unsustainable.

That's according to Capital Economics' chief market economist John Higgins, who said in a note on Wednesday that the relative outperformance of small-cap stocks compared to large-cap stocks is likely to be short-lived.

"A recent surge in the Russell 2000 after the US CPI report for June was published last week has prompted claims that we are entering the initial stage of a secular rotation into US small-cap stocks. We are not convinced," Higgins said.

First, Higgins said the recent market action shouldn't be thought of as a rotation.

A rotation implies that investors are selling large-cap stocks and using those proceeds to buy small-caps. But while large-caps have sat out the rally over the past week, they are still just a few percentage points below all-time highs.

"We would need to see more evidence of a sell-off in 'big tech' to be convinced that a rotation into small-cap stocks out of their larger counterparts was well and truly underway," Higgins said.

Higgins made those comments while acknowledging the sharp decline in mega-cap tech stocks on Wednesday, sparked by comments from former President Donald Trump and the Biden administration considering restrictions on certain semiconductor companies.

Much of the rally in small-cap stocks has been driven by the expectation that the Federal Reserve will soon lower interest rates.

But Higgins isn't buying that argument either, noting that large-cap stocks outperformed their small-cap peers when the Fed cut interest rates in the mid-1990s, as well as when they cut interest rates in 2009 and 2019.

"We anticipate a bubble in the stock market continuing to inflate amid hype around AI, like one did in the second half of the 1990s around the internet. Back then, small-cap stocks generally underperformed their large-cap peers until mid-1999," Higgins said.

Finally, Higgins highlighted that the biggest factor driving stock market performance is earnings, and there's no sign yet that small-cap stocks are going to overtake large-cap stocks in terms of earnings growth.

"It remains to be seen whether big tech firms will fail in general to continue to beat analysts' lofty expectations for their earnings," Higgins said.

The first round of second-quarter earnings results for the mega-cap tech companies are set to drop next week with reports from Tesla and Alphabet.

While Higgins isn't yet buying into the small-cap stock rally, Fundstrat's Tom Lee is.

The strategist told clients on Tuesday that he still sees a 40% rally occurring in small-cap stocks after they've largely sat out the broader stock market rally this year.

"We have small caps even more oversold and valuations — whether you look at medium P/E, which is now at 10 times 2025 earnings — even lower," Fundstrat's Tom Lee told CNBC. "So we think that this move could be something like 10 weeks and as much as 40%. So I think it is just starting."