After years of suffering, "risk factors" returning, could the US small-cap stocks usher in a "long-term bull market"?

For investors who are fond of small-cap stocks, the past few years have been extremely challenging. These stocks have not been able to break out of a strong long-term bull market trajectory like the S&P 500 index and the Nasdaq 100 index since the end of 2022. However, after years of painful periods, the "risk factor" seems to be making a comeback, and therefore the stocks with the highest market risk in the stock market are finally seeing increasingly strong long-term bull market momentum. The last time the Russell 2000 Index, the benchmark for small-cap stocks in the US market, hit a new high was on November 8, 2021, and it has not been able to surpass this historical high since then, currently only about 3% away from that level. Unless there are major changes in the market situation by Friday, this will mark the longest period of "no new highs" for the small-cap benchmark index in the US market since around the year 2000 when the dot-com bubble burst. In contrast, the S&P 500 index, the benchmark index for large-cap stocks in the US, has set 19 new historical records since the beginning of this year - a total of 19 new highs as of 2025. At the same time, as market expectations for a rate cut by the Federal Reserve continue to increase, the investment sentiment for small-cap stocks is becoming more optimistic, mainly because small-cap stocks have been strong for several weeks, outperforming the S&P 500 index and the Nasdaq. A study by Bank of America on Wall Street shows that the signal of "rate cut as soon as September" released by Fed Chairman Powell at the Jackson Hole annual meeting has provided important bullish support for the small-cap stock market. Bank of America stated that recent economic data shows the resilience of the US economy and the "soft landing" of the economy is approaching, as well as traders in the interest rate futures market betting that the Fed may cut rates twice starting in September and thereby restart the rate-cutting cycle. Currently, small and mid-cap stocks (especially small and micro-cap stocks) are facing structural opportunities, but need to focus on high-quality and fundamental factors to hedge against economic downturn risks. Bank of America strategists stated that under the macro background of the Fed's rate cut, the performance of small and mid-cap stocks may far exceed the seven major tech giants in the US stock market and the broad market stocks, mainly because small and mid-cap stocks are often very sensitive to the benchmark interest rates set by the Fed. They are highly dependent on floating rate loans, so in the context of a Fed rate cut, it means that the substantial debt pressure they have faced for a long time will be greatly reduced, thereby potentially increasing profit margins and stock valuations. With a rate cut in sight and momentum picking up, the Russell 2000 Index is leading the market's counterattack. Statistics show that the Russell 2000 Index has risen 7.3% in August so far, leading the entire US stock market, making it the best performing month relative to the benchmark S&P 500 index since July 2024. With the Fed seemingly preparing to announce a rate cut at the next FOMC monetary policy meeting, there are ample reasons and logic to expect a larger scale rise in this index, focusing on the regional small and mid-sized banks and small technology and industrial companies that may benefit from a more accommodative monetary policy, which have a high weight in the Russell 2000 Index. "The potential for the small-cap index to continue to rise is clearly there, and it may be much stronger in the future than the large-cap index," said Matt Maley, chief market strategist at Miller Tabak + Co. "You now have a much stronger momentum, a momentum that has been missing for a long time." A long time without hitting new highs - the duration of small-cap stocks not hitting new highs may set a record for the longest period since the dot-com bubble burst Maley said another key bullish signal comes from the iShares Russell 2000 Index ETF (ETF code: IWM), which is trading above $230, breaking a crucial technical level. Despite this, he still cautioned investors to beware of overly excited market sentiment. Maley's bullish stance on small-cap stocks is not alone in the market. RBC Capital Markets also sees potential for small-cap stocks to outperform the S&P 500 index and the Nasdaq 100 index, focusing on the macro expectations of the Fed restarting the rate-cutting cycle. The current US capital market presents a pattern of "large caps overvalued, small companies undervalued": a few tech giants are valued significantly higher while most stocks are not overheated. In addition to the improvement in the macro environment and expectations of a turn towards accommodative monetary policy, investors are starting to prepare for possible style rotations, shifting from the hot and overvalued tech giants to the long-ignored high-quality fundamental small and mid-cap stocks. Looking at the entire US stock market, the seven major tech giants have been the strongest engine driving the whole market since 2023, attracting global funds with their strong market dominance, robust fundamentals, years of strong free cash flow reserves, and expanding stock buyback sizes. However, the valuations of these tech giants at historical highs have made Wall Street increasingly cautious - six of the seven tech giants are expected to have a forward P/E ratio significantly higher than the S&P 500 index valuation, while the valuation of the S&P 500 index itself is also near historical highs. But RBC also emphasizes the need to focus not only on the dynamic of the Fed rate cut expectations but also on the fundamentals of the economy. "We still do not believe that a sustainable period of small-cap outperformance against large-cap stocks or tech giants can be achieved solely by the Fed rate cut, unless the economic backdrop is stronger than currently predicted or widely expected in the economics field," wrote Lori Calvasina, head of US stock strategy research at RBC Capital Markets in a report to clients on August 24. Some traders remain skeptical and recommend cautiously positioning in small-cap stocks through options At the same time, signals from the options market show that some traders are skeptical about the strength and potential duration of this large rebound in small-cap stocks. "Overall positioning is still very bearish," said Daniel Kirsch, head of options trading at Piper Sandler in a research note. Maley suggests that the fate of the Russell 2000 may depend on the performance of the largest tech giants in the US. If Nvidia, Amazon, Apple, and the rest of the "Magnificent 7" continue to rise, or at least maintain their historical high valuations, this will encourage investors to rotate funds from large-cap stocks into other sectors of the market, especially small-caps, provided that the tech giants do not experience a major collapse in stock prices. However, if the valuations of the tech giants start to collapse or the fundamentals of the US economy deteriorate, the trend of small-cap stocks may begin to look suspicious. "Market breadth and rotation are two different things," Maley said in an interview. "As long as large-cap tech stocks are still on an upward trajectory and valuations remain stable, you will get a big rotation rally." However, he added that if the stock prices of large-cap tech giants start to collapse, risk appetite indicators and the entire market will also decline, with sellers liquidating funds back to cash instead of rotating from large-cap stocks to the higher-risk small-cap stocks. To bet that the Russell 2000 Index will ultimately surpass its historical high without occupying capital in stocks, Wall Street professionals from Susquehanna International Group, Piper Sandler, and RBC recommend buying bullish spreads on the IWM ETF. In this type of options trade, investors sell bullish option contracts betting on a significant rise in the ETF, providing partial funds for contracts betting on a more limited increase. "As investors return from the holiday, you will see more people willing to deploy tactical interest rate-sensitive trading strategies ahead of the September Fed meeting," wrote Amy Wu Silverman, head of derivatives strategy at RBC, in an email. "The IWM bullish spread is a good way to 'rent' such trades." In simpler terms, it allows investors who have been "burned" by betting on small-cap stocks in the past to protect themselves while capturing some upside potential. "If you're not sure because you've been fooled too many times by false breakouts, this is an alternative," said Christopher Jacobson, co-head of derivatives strategy at Susquehanna International Group.