The Fed's Interest Rate Cut Could Make Small Cap Stocks a Good Investment

mU.S. small-cap stocks have surged over the past month, spurred by expectations that the Federal Reserve will soon lower interest rates for the first time since 2020. However, despite this rally, there is still uncertainty among investors regarding the sustainability of these gains, especially in one of the market's more volatile segments.

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The Russell 2000 Index, which tracks the performance of 2,000 small and midsize companies within the Russell 3000 Index, has risen by over 2% in the past month. This performance has outpaced the large-cap benchmark S&P 500's 1.4% gain and the Nasdaq Composite's 0.2% decline during the same period, according to data from FactSet.

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Small-cap stocks have experienced significant volatility since the Federal Reserve hinted at an impending rate cut earlier this summer. The Russell 2000 saw a remarkable 13% jump in July, marking its best month in almost two years, only to lose nearly half of that gain in August. Now, some market analysts believe this bullish momentum might continue.

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Many market participants are optimistic that smaller companies will continue to outperform the broader market in the coming months. This optimism is primarily driven by the expectation that the Federal Reserve will begin reducing interest rates, as well as the possibility of the U.S. economy achieving a "soft landing"—a slowdown in economic growth that avoids a recession.

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Small-cap companies are typically more sensitive to changes in borrowing costs and economic conditions than larger companies. This sensitivity arises because small-cap firms often carry higher levels of debt and rely more heavily on external financing to fund their operations. Therefore, lower interest rates can significantly benefit these companies by reducing their borrowing costs.

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From a valuation perspective, small-cap stocks appear more attractive compared to their larger counterparts. As of September 16, the forward 12-month price-to-earnings (P/E) ratio for the S&P SmallCap 600 stood at around 16.7, whereas the P/E ratio for the S&P 500 was 23.4. Additionally, earnings for small-cap companies are projected to grow at a faster rate, with an expected 20% increase in 2025, compared to the S&P 500's projected 15% rise.

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Matt Palazzolo, a senior investment analyst at Bernstein Private Wealth Management, notes that the combination of a valuation discount, potential earnings growth, and the cyclical nature of small-cap stocks could make them more appealing if the Federal Reserve starts to cut rates. In his view, such a move could serve as a catalyst for increased investor interest in small-cap companies.

While it is widely expected that the Federal Reserve will begin easing monetary policy soon, the magnitude of the rate cut remains uncertain. According to the CME FedWatch Tool, traders in the federal-funds futures market on Monday saw a 63% probability that the central bank would announce a half-point cut later this week, up from around 40% on Friday. There was a 37% chance of a more modest 25-basis-point cut.
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A larger, 50-basis-point rate reduction could provide additional support for the small-cap trade, according to Jonathan Krinsky, chief market technician at BTIG. However, some concerns linger. A significant rate cut could signal that the U.S. economy is slowing more rapidly than anticipated, potentially hurting corporate earnings and the broader financial markets.

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Jordan Irving, portfolio manager at Glenmede Investment Management, points out that the final piece of the puzzle for investors to fully commit to small-cap stocks is evidence of above-trend earnings growth within the group. Thus far, this growth has not materialized, which has led to some hesitation in fully embracing small-cap equities.

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Nevertheless, Palazzolo advises small-cap investors not to get too caught up in the debate between a 25- or 50-basis-point cut. He suggests that while the magnitude of the cut will affect short-term stock market performance, it may not significantly impact the long-term relationship between small-cap and large-cap trades.

Jay Hatfield, CEO of Infrastructure Capital Advisors and portfolio manager of the InfraCap Small Cap Income ETF, attributes the recent outperformance of small-cap stocks to the ongoing "value versus growth" narrative. Earlier this summer, the rally in the so-called "Magnificent Seven" group of megacap tech companies faced a setback, paving the way for value and income stocks to gain traction.

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Hatfield points out that some small-cap indexes are heavily weighted toward stocks in rate-sensitive and dividend-paying sectors, such as financials and real estate. He suggests that when investors inquire about the potential for small caps to outperform, they are often questioning whether large-cap value and income stocks will lead, which could subsequently benefit their smaller-cap counterparts in the same sectors.

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In the past three months, the financials sector of the S&P SmallCap 600 has been the second-best performer among the index's 11 sectors, gaining 20.7%. The real estate sector also advanced 18.5% during the same period. These sectors were among the top performers in the large-cap S&P 500 as well.

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Meanwhile, the Russell 2000 Value Index surged 11.1% over the past three months, compared to a 7.2% increase in the Russell 2000 Growth Index, according to FactSet data.

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In summary, the recent rally in small-cap stocks, fueled by the anticipation of Federal Reserve rate cuts, has sparked optimism about their future performance. However, uncertainties around the size of the rate cut and broader economic conditions still have investors questioning the sustainability of these gains. While small-cap valuations and projected earnings growth appear favorable, the ultimate outcome will depend on a variety of factors, including the Fed's actions and the broader economic environment.

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