The Fed's rate cut brings the focus back to small-cap stocks, ushering in a new era of post-giant wave.

During most of the time when the US stock market saw record-breaking gains, small-cap stocks seemed to be in a wait-and-see mode, especially during the period of strong gains in the benchmark S&P 500 index since the beginning of the year, when it repeatedly hit new highs. The small-cap benchmark Russell 2000 index failed to sustainably reach historical highs like the S&P 500 index. Now, driven by the continued anticipation of rate cuts by the Federal Reserve, the markets "animal spirits" have fully returned. They have finally joined the investment feast in recent times, almost ending the period of underperformance against the S&P 500 index since the outbreak of the COVID-19 pandemic. During Wednesday's US stock trading session, the Russell 2000 index rose by 2.1% to 2453.36 points at one point on Wednesday, surpassing its historical closing high since November 2021 for the first time, before giving back some gains and pulling back from that level. The index ended up rising by 0.2%. Although the index has yet to break the historical high set in November 2021, the brief surge after the Fed announced a 25 basis point rate cut, and the recent outperformance against the S&P 500 index driven by expectations of Fed rate cuts, indicate that the market is increasingly favoring small-cap stocks under the backdrop of rate cuts. The Russell 2000 index was on the verge of surpassing its historical closing high before giving back gains. The Fed's rate cut, which was already 100% priced in by the market, propelled the Russell 2000 index higher, despite lower performance in the broader US stock market on the same day. After months of pressure from the Trump administration for aggressive rate cuts, the FOMC monetary policy dot plot showed that the Fed preliminary plans to cut rates twice more this year after the latest 25 basis point rate cut. The Fed's first rate cut in nine months was certainly in line with market expectations. The most watched FOMC dot plot suggested that the Fed is expected to cut rates three times this year, one more time than the previous dot plot, and is expected to cut rates again next year. Following the Fed's rate cut decision, Nick Timiraos, a well-known journalist from The Wall Street Journal and often referred to as the "Fed mouthpiece," wrote that concerns about a slowing job market outweighed concerns about inflation, providing a reason for the Fed to make a minor rate cut. The Fed's policy stance is shifting towards a broader focus on job market weaknesses. Additionally, in the post-rate cut policy statement, the Fed did not reaffirm the comments about a robust labor market as before, but instead mentioned slowing job growth and a slight rise in the unemployment rate, stating that job growth had slowed and the unemployment rate had slightly risen but remained low; inflation had also risen slightly, remaining high. This modification in the statement signaled the start of a new rate cut cycle by the Fed. This statement reiterated the focus of the Fed FOMC monetary policy committee on the risks facing its dual mandate of achieving full employment and price stability, with an added assessment of increased downside risk to employment. The statement read: "The Committee is monitoring the implications of these developments for the economic outlook and will act as appropriate to sustain the expansion." The Russell 2000 index is poised to follow a trajectory of repeated highs and lead the markets rebound. For investors who favor small-cap stocks, the past few years have been very challenging as these stocks have failed to perform as strongly as the S&P 500 index and the Nasdaq 100 index since the end of 2022. However, after years of a painful period, the "risk factors" seem to be making a full comeback, and the stocks with the highest market risks are finally seeing stronger long-term bullish momentum. With the market's continued anticipation of Fed rate cuts, the sentiment towards small-cap stocks is becoming more positive. Currently, the US capital market shows a pattern of "overvaluation of large companies and undervaluation of small companies": a few technology giants have high valuations while most stocks remain not overheated. Coupled with improvements in the macro environment and expectations of a turning point in monetary policy easing, investors are preparing for possible style rotations, shifting from the highly valued technology giants that have hit historical highs to the long-overlooked high-quality small and mid-cap stocks with solid fundamentals. The so-called "Magnificent Seven," which account for about 35% of the S&P 500 index and the Nasdaq 100 index, including Apple, Microsoft, Google, Tesla, Nvidia, Amazon, and Meta Platforms, are the core driving forces behind the repeated highs of the S&P 500 index. Undoubtedly, based on historical patterns, the restart of a Fed rate cut cycle is initially beneficial for small-cap stocks. If the Fed rate cut cycle officially starts and the US economy remains resilient with a "soft landing," the momentum of US stocks is very likely to continue rotating into the mid and small-cap stocks that have suffered from significant price declines since 2022. These stocks are highly sensitive to rate expectations, and even a minor rate cut could boost their stock prices and valuations, especially for high-quality mid and small-cap stocks supported by performance. Therefore, according to some Wall Street analysts, the Russell 2000 index is expected to follow a trajectory of repeated highs similar to the S&P 500 index this year and lead the entire market's rebound. A study by Bank of America's Wall Street team shows that in the macro environment of Fed rate cuts, the performance of mid and small-cap stocks may far exceed that of the US tech giants and the broad market stocks. The primary logic is that mid and small-cap stocks are often highly sensitive to the benchmark interest rates set by the Fed and rely heavily on floating-rate loans. Thus, the backdrop of Fed rate cuts implies a significant reduction in the long-standing debt pressures for these companies, potentially boosting profit margins and stock valuations. In the view of the Bank of America strategy team, mid and small-cap stocks have a stronger "spring effect": the lower they were pushed down previously, the greater the rebound potential later. Bank of America's long-term forecast indicates that small-cap stocks have the potential to outperform the seven giants-dominated broad market in the next decade. If the US economy avoids a recession in the next 12-24 months and interest rates enter a downward trend, with the market entering the "post-giant era" (where the rising trend of the broad market led by the seven giants gradually gives way to high-quality mid and small-cap stocks), mid and small-cap stocks may experience a "double increase" in profits and valuations, with cumulative excess returns expected to significantly outperform the broad market. "A few months ago, small-cap stocks seemed to be on their last legs," said Irene Tunkel, Chief US Equities Strategist at BCA Research. "Small-cap stocks are indeed cheap and have long been neglected, but they are poised for a significant rebound. Coupled with expectations of Fed easing, new tax breaks from OBBA, and more impressive profit forecasts, this rally suddenly has strong momentum." A once brief but new record has marked the remarkable return of the Russell 2000 index. Since its low point in April, the index has rebounded by over 36%, when the market was deeply worried about Trump's aggressive global "Liberation Day" tariff policies and expectations for the revival of small-cap stocks under the "America First" agenda fell short. "The significant rebound of small-cap stocks in recent times aligns with the rising risk appetite and market expectations of three rate cuts by the Fed this year," said Doug Beath, Global Equity Strategist at the Bank of America Investment Research Institute. Steven DeSanctis, Stock Market Strategist at Jefferies, pointed out that the macroeconomic backdrop favors small-cap stocks, and the second-quarter earnings data in the small-cap sector has been better than market expectations. "Second-quarter earnings for small-cap companies have been quite good, exceeding our expectations; and the market expects the profit growth of small-cap companies to outpace that of large-cap stocks and the 'Magnificent Seven' later this year or next year," DeSanctis said. Bloomberg Intelligence strategist Michael Casper stated that the revenue of small-cap stocks is gradually approaching that of large-cap peers in the market, with total sales expected to eventually surpass the interim peak in 2022, indicating that small-cap stocks still have further upside potential. "If the Fed rate cut successfully stimulates a soft landing for the economy, current market expectations for revenue may be too low, which will give the Russell 2000 index the opportunity to outperform the broad market in the end," Casper wrote in a report released on September 11. Rising expectations are likely to fuel the continued momentum of small-cap stocks. The Russell 2000 index came close to ending its "drought of record highs" at the end of 2024 but then sharply reversed due to concerns stemming from tariffs. Since its last record in November 2021, other major US benchmark indices have hit dozens of new highs, especially the S&P 500 index, which has already set over 20 new highs this year, but the Russell 2000 index has always failed to reach historical highs. In recent weeks, there has been a significant increase in bullish momentum in the market, and strategists are gradually shifting towards optimism for small-cap stocks. The team of strategists led by David Kostin at Goldman Sachs believes that the expectations of rate cuts and corporate profit recovery will spread this record-breaking market trend to long-neglected areas like small-cap stocks. At the same time, Michael Wilson, Chief Equity Strategist at Morgan Stanley, pointed out that there is still significant room for upside in rate-sensitive sectors like small-cap stocks. After Fed Chairman Powell sent a dovish signal at the August Jackson Hole meeting, Bank of America and UBS Group also joined the camp of long-term optimism for small-cap stocks outperforming. "I really think the 'animal spirit' is coming back," DeSanctis said, noting an increase in merger activities as the market has largely moved past tariff concerns and pessimistic narratives, and relaxed regulation has started to have positive effects. "There are also more secondary IPO activities. Overall, capital market activity picking up is good news for small-cap stocks." Finally, the rising expectations for rate cuts helped the Russell 2000 index challenge its previously unattainable historical highs. As about half of the index's components are still not profitable, the rate cut provides a strong boost for this leveraged group. "Interest expenses account for a significant portion of small-cap earnings, and lower short-term rates will help significantly reduce this burden," said Beath of the Bank of America Investment Research Institute. Despite the potential decrease in interest costs, Beath also cautioned, "lower-quality" small-cap stocks are more vulnerable to the friction caused by Trump's tariff agenda, as they have thinner profit margins and weaker supply chain resilience. Based on this, Beath continues to prefer US large-cap stocks and mid-cap stocks and maintains a cautious view on small-cap stocks. Small-cap stocks are undoubtedly enjoying the continued shine of bullish sentiments, but the trend of outperforming the broad market remains uncertain. Kostin of Goldman Sachs believes that small-cap stocks still have room for better performance in the short term, but he does not believe this trend will continue in the next 12 months. For Irene Tunkel, Chief US Equities Strategist at BCA Research, small-cap stocks still have attractive valuations, but the existing headwinds cannot be ignored. "The rebound is impressive, but many small companies are facing rising costs and narrowing profit margins, which could make this rally fragile," Tunkel said.