Small-cap Stocks Are Roaring Back After Being Battered Down. The Reasons Why They Might Soar in 2024.

Small-cap stocks, a segment of the stock market that has faced challenges, are wrapping up the year on a positive note, and there is potential for a robust rally in 2024, especially if the Federal Reserve decides to cut rates. Analysts and investors believe that the impressive performance of small caps in December could continue into the new year.

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The Russell 2000, composed of the 2,000 smallest companies by market capitalization in the Russell 3000, has surged by 12.4% in December. This outpaces the 4.1% rise in the S&P 500, a benchmark for large-cap stocks, through Friday's close. Despite this December rally, small caps are still playing catch-up, with the Russell 2000 showing a 15.5% gain for the year, compared to the S&P 500's 23.8%.

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The potential for further gains in small-cap stocks in 2024 is closely tied to the Federal Reserve's decisions on interest rates, according to analysts. Tom Lee, the head of research at Fundstrat, is particularly optimistic, expecting small-cap stocks to climb up to 50% in the next 12 months. He envisions the Russell 2000 reaching as high as 3,000 by the end of 2024. However, the index is currently over 16% below its record close in November 2021.

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Lee emphasizes that the performance of small-cap stocks will be influenced by the Fed's stance on interest rates. If the Fed becomes less aggressive in raising rates, small-cap stocks, especially those with higher leverage, are likely to benefit from rate cuts.

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Small-cap companies have been grappling with higher interest expenses since 2022 when the Fed increased its key interest rate 11 times, reaching a range of 5.25% to 5.5%, a 22-year high. Fed Chair Jerome Powell's indication of a potential pivot to rate cuts in 2024 has provided relief to equity bulls, especially in the small-cap space.

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The sensitivity of small-cap stocks to interest rates is due to their weaker balance sheets and higher percentage of debt, with a significant portion being variable-rate debt. Unlike their larger counterparts, small-cap companies have an average debt maturity of approximately 5.5 years, making them more vulnerable to changes in interest rates.

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As the Fed signals a shift toward rate cuts in 2024, small-cap stocks are starting to catch up. Traders are pricing in a total of 150 basis points of rate cuts in 2024, surpassing the 75 basis points penciled in by the Fed. This optimism about rate cuts has fueled the December rally of the Russell 2000, outperforming the S&P 500 by 8.3 percentage points.

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Looking ahead to 2024, factors such as the end of the rate-hike cycle, decreasing inflation, a robust labor market, and strong consumer spending could further support the performance of small-cap stocks. Analysts suggest that historical patterns indicate a potential turnaround for small-cap stocks, which have seen lackluster returns in recent years.

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However, caution is advised, and evidence of a soft landing is necessary to ensure the sustained rally of small-cap stocks. If the market experiences a corporate profit recession or consumer contraction in 2024, small caps may underperform. Investors are urged to monitor the earnings of small-cap companies in the first quarter of the new year to assess the sustainability of the rally. Overall, the trajectory of small-cap stocks will depend on various economic factors, and a close watch on developments will be crucial for investors in 2024.