Small Caps Are the Hottest Trade Going in the Stock Market Right Now and They're Surging Again This Tuesday

Small-cap stocks have recently surged, taking the lead from megacap technology shares to drive the bull market. Investors are optimistic that anticipated interest rate cuts will stimulate the economic recovery, benefiting these smaller companies.

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The Russell 2000 index, a key benchmark for small-cap stocks, climbed 2% on Tuesday. This followed a peak on Monday, marking its highest level since January 2022. Should the index rise an additional 1% on Tuesday, it would be the fifth time since 1979 that it has experienced a five-day streak of gains exceeding 1%, according to Bespoke Investment Group.

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Over the past month, the Russell 2000 has surged 11%, nearly three times the gains seen in the S&P 500. Tom Lee from Fundstrat, known for his accurate market predictions, suggests that the rally in small caps could extend for over two months, with significant gains expected for these stocks.

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"We think this move could be something like 10 weeks and as much as 40%. I think it is just starting," said Lee, Fundstrat's head of research, during an appearance on CNBC’s “Closing Bell: Overtime” on Monday.

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Investors are shifting their focus to previously overlooked market segments, spurred by last week's inflation data, which suggested that the Federal Reserve might soon cut interest rates, potentially avoiding a recession. Small-cap stocks, which are generally more responsive to economic changes and market sentiment, could benefit significantly from lower interest rates.

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Additionally, small caps are gaining favor among investors as part of the “Trump trade.” This term refers to investments anticipated to benefit from policies associated with former President Donald Trump, who is seen as a potential victor in the upcoming November election.

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Although Trump has not outlined specific policies for a second term, his approach of raising tariffs while cutting taxes and regulations could boost domestic stocks, including small caps, according to David Kostin, chief U.S. equity strategist at Goldman Sachs.

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Trump's odds in betting markets have been improving, especially following his debate against President Joe Biden in June and his recent survival of an assassination attempt over the weekend. Investors are speculating that his potential return to office could further drive small-cap stocks.

The surge in small-cap stocks can be attributed to a variety of factors. Historically, these stocks tend to outperform in environments where interest rates are declining. Lower borrowing costs can significantly enhance the profitability and expansion potential for smaller companies, which often rely more heavily on credit compared to their larger counterparts.

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Moreover, the anticipation of a broader economic recovery plays a crucial role. As economic conditions improve, smaller companies, which are typically more nimble and adaptive, can quickly capitalize on new opportunities. This adaptability can lead to substantial growth, especially when supported by favorable monetary policies.

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The current rally also reflects a broader trend of market rotation. Investors are moving away from the high-flying technology stocks that dominated much of the bull market, seeking opportunities in undervalued or overlooked sectors. Small caps, which have lagged behind their larger peers in recent years, present a compelling investment case under these circumstances.

The potential political impact of Trump’s re-election bid cannot be understated. Markets are forward-looking and often react to anticipated policy changes. Trump's previous tenure saw significant deregulation and tax cuts, which were favorable for businesses. If investors believe that similar policies will be reinstated, they may increase their exposure to domestic stocks, particularly those that stand to benefit the most, such as small caps.

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Additionally, Trump's trade policies, which included higher tariffs on foreign goods, aimed to boost domestic manufacturing and reduce the trade deficit. Such measures could provide a competitive advantage to smaller U.S. companies that compete with foreign producers.

Looking ahead, the performance of small-cap stocks will likely remain closely tied to the trajectory of interest rates and broader economic indicators. Should the Federal Reserve move towards cutting rates, this could further propel the rally in small caps. However, investors should remain mindful of potential volatility, as small-cap stocks are typically more susceptible to economic fluctuations.

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In conclusion, the recent surge in small-cap stocks underscores the dynamic nature of financial markets. As investors reposition their portfolios in response to evolving economic and political landscapes, small caps are emerging as a significant beneficiary of these changes. Whether driven by expectations of interest rate cuts, economic recovery, or potential political shifts, the current momentum suggests a promising outlook for this segment of the market.

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