It might be time to go 'bargain hunting' for small cap stocks

The Russell 2000 (^RUT) just had its best week in more than two years.

Beaten-down areas of the market surged as investors increasingly bet on the Federal Reserve being done with its interest rate hike cycle. And even after a more than 7.5% increase in the index, RBC capital markets head of US equity strategy Lori Calvasina still sees opportunity as several traditional tailwinds for small caps take hold.

"They tend to lag late in economic cycles and so there's really a sense when times get dicey that's when you want to go bargain hunting in the small cap space in particular," Calvasina told Yahoo Finance Live on Monday.

This could be crucial in the current economic moment. The most recent jobs report released on Friday showed unemployment at its highest level in nearly two years. Data out last week showed the activity in the US services sector just hit a five-month low. And while the economy has overall remained resilient, if the cracks many are seeing at the surface proliferate into a period of slower economic growth, small caps "tend to price in economic problems ahead of time," Calvasina wrote in a research note out Monday.

Beyond the economic picture, other factors point to solid position for small caps, per Calvasina. For starters, markets are increasingly confident the Fed may be done done hiking rates, a known headwind for small caps. This comes as valuations on the index are looking increasingly attractive.

The Russell 2000 hasn't been this cheap compared to the S&P 500 since the tech bubble in the late 1990s into the early 2000s, per Calvasina.

"That's causing some multi-asset investors to take notice," she said.

But as Calvasina highlights, small caps have lagged for a reason over the past year. The group of stocks has more debt set to mature in the next five years than most large cap companies, which Calvasina said has been a top concern in conversations with investors. Broadly, investors have been wary of how a higher cost to finance debt could impact those companies moving forward and potentially weigh on growth.

"Unless interest rates reverse lower, interest expense should continue to eat into small-caps' earnings," Ed Clissold, Ned Davis Research chief US strategist, wrote in a research note on Sept. 21. "Lower expected earning growth for small-caps is one of the reasons we favor large-caps over small-caps."

Still, Calvasina argues that small caps should be able to hold up amid the higher rate environment. She highlights not all of the debt is due next year. RBC's research shows 40% of small caps' debt is set to mature over the next two to five years, meaning rates could be at different levels by then as many expect the Fed to start cutting interest rates at some point in 2024.

Additionally, Calvasina leans into the historical state of interest rates and points out the current effective interest rate is still historically low.

"To be sure, [the effective interest rate] is creeping up and will continue to rise," Calvasina said. "But we don’t think it’s well understood how much lower the starting point is today relative to past cycles."