After years of suffering, the "risk factor" returns, and U.S. small-cap stocks welcome a "long-term bull market"?

For investors who are fond of small-cap stocks, the past few years have been very challenging, as these stocks have not been able to exhibit the incredibly strong long-term bull market trajectory seen in 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 showing a comprehensive return, and thus the stocks with the highest market risk are finally seeing increasingly strong long-term bullish momentum.

The benchmark for small-cap stocks in the U.S. market—the Russell 2000 Index—last reached an all-time high on November 8, 2021, and has since failed to break through this historical peak, currently sitting just about 3% below that level. Unless there is a significant change in market conditions by Friday, this will mark the longest period of "not reaching a new high" for this small-cap benchmark since the bursting of the internet bubble around 2000. In contrast, the large-cap benchmark index in the U.S. market—the S&P 500 Index—has set as many as 19 historical records this year alone, achieving 19 new highs since the beginning of 2025.

Meanwhile, as market expectations for a Federal Reserve interest rate cut continue to heat up, investor sentiment towards small-cap stocks has begun to become more optimistic, mainly because small-cap stocks have been on a strong upward trend for several weeks, outperforming the S&P 500 Index and the Nasdaq. A study by Bank of America, a major Wall Street firm, indicates that the "earliest rate cut in September" signal released by Federal Reserve Chairman Jerome Powell at the Jackson Hole annual meeting has provided significant bullish support for small-cap stocks.

Bank of America stated that recent economic data shows the U.S. economy is remarkably resilient and that a "soft landing" for the economy is approaching. Additionally, traders in the interest rate futures market are betting that the Federal Reserve may cut rates twice starting in September this year, thereby restarting the rate-cutting cycle. Currently, small and mid-cap stocks (especially small and micro-cap stocks) are welcoming structural opportunities, but it is essential to focus on high-quality and fundamental factors to hedge against economic downturn risks.

Bank of America strategists indicated that under the macro backdrop of the Federal Reserve initiating rate cuts, the performance of small and mid-cap stocks may far exceed that of the seven major tech giants in the U.S. stock market and the broader large-cap stocks. The main logic is that small and mid-cap stocks are often very sensitive to the benchmark interest rates set by the Federal Reserve; they heavily rely on floating-rate loans. Therefore, in the context of the Federal Reserve cutting rates, this means a significant reduction in their long-standing debt pressure, which is expected to improve profit margins and stock valuations.

With rate cuts on the horizon and momentum warming up, the Russell 2000 Index leads the market rebound

Statistical data shows that the Russell 2000 Index has risen 7.3% so far in August, leading the entire U.S. stock market, marking the best month relative to the large-cap benchmark—the S&P 500 Index—since July 2024. As the Federal Reserve seems prepared to announce rate cuts at next month's FOMC monetary policy meeting, there is ample reason and logic to expect that this index will achieve larger gains, particularly benefiting regional small banks and small technology and industrial companies that hold significant weight in the Russell 2000 Index due to more accommodative monetary policies.

"The potential for this small-cap index to continue rising is clearly present, and it may be much stronger than the large-cap in the future," said Matt Maley, Chief Market Strategist at Miller Tabak + Co "You now have stronger upward momentum, which has been severely lacking for a long time."

Long time without new highs - The duration of small-cap stocks not reaching new highs is expected to set the longest record since the burst of the internet bubble.

Maley stated that another very critical bullish signal comes from the iShares Russell 2000 ETF (ETF code: IWM), which is trading above $230, breaking through a crucial technical level. Nevertheless, he still warns investors to be cautious of overly excited market sentiment.

Maley's bullish stance on small-cap stocks is not an isolated view in the market; RBC Capital Markets is also optimistic that small-cap stocks are likely to outperform the S&P 500 index and the Nasdaq 100 index, which focuses on tech giants, under the macro expectations of a resumption of the Federal Reserve's interest rate cut cycle.

Currently, the U.S. capital market presents a pattern of "large caps overvalued, small companies undervalued": a few tech giants are highly valued while most stocks remain not overheated. Coupled with the improvement in the macro environment and expectations of a turning point in monetary policy easing, investors are beginning to prepare for a possible style rotation, shifting from the hot but historically high-valued tech giants to undervalued quality small-cap stocks with solid fundamentals.

Looking at the entire U.S. stock market, the seven major tech giants have been the strongest engine driving the entire U.S. stock market since 2023. They attract global funds with their strong market advantages, robust revenue from AI, solid fundamentals, years of strong free cash flow reserves, and expanding stock buyback scales. However, the historically high valuations of these seven giants make Wall Street increasingly cautious—six of the seven tech giants are expected to have price-to-earnings ratios far exceeding 25x, which is the valuation of the S&P 500 index, while the benchmark S&P 500 index is also near its historical highest valuation.

However, RBC also emphasizes that it is necessary to pay attention not only to the dynamics of the Federal Reserve's interest rate cut expectations but also to the fundamentals of the economy. "We still do not believe that a sustainable period of small-cap stocks outperforming large-cap stocks or tech giants can be achieved solely through Federal Reserve interest rate cuts, unless the economic backdrop is stronger than current or widely predicted by economists," wrote Lori Calvasina, head of U.S. equity strategy research at RBC Capital Markets, in a report to clients on August 24.

Some traders remain skeptical, suggesting a cautious approach to small-cap stocks through options.

Meanwhile, signals from the options market indicate that some traders are skeptical about the strength and potential duration of this small-cap stock rally. "Overall positioning remains very bearish," said Daniel Kirsch, head of options at Piper Sandler, in a research report Maley stated that the fate of the Russell 2000 may depend on the stock performance of the largest technology giants in the United States. If Nvidia, Amazon, Apple, and the remaining "Magnificent 7" continue to rise in price, or at least maintain their historically high valuations, this will encourage investors to rotate funds from large-cap stocks into other sectors of the market, especially small-cap stocks, provided that the tech giants do not experience a major collapse in stock prices. However, if the valuations of the tech giants begin to collapse or the fundamentals of the U.S. economy deteriorate, the trend for small-cap stocks may start to appear questionable.

"Market dispersion and rotation are two different things," Maley said in an interview. "As long as large tech stocks remain on an upward trajectory and valuations are stable, you can expect a significant rotation." However, he added that if large tech giants generally collapse in stock prices, risk appetite indicators and the overall market will also decline, with sellers liquidating funds back into cash rather than rotating from large-cap stocks to riskier small-cap stocks.

To bet that the Russell 2000 index will eventually break through its historical high without tying up capital in stocks, Wall Street professionals from Susquehanna International Group, Piper Sandler, and RBC have suggested buying call spreads on the IWM ETF. In this options trade, investors sell call options betting on a significant rise in the ETF to partially fund contracts betting on more limited upside.

"As investors return from the holidays, you will see more people willing to deploy tactical interest rate-sensitive trading strategies ahead of the September Fed meeting," RBC's head of derivatives strategy, Amy Wu Silverman, wrote in an email. "The IWM call spread is a good way to 'rent' such trades."

Or more simply, it allows those investors who have been "burned" by small-cap stock bets to capture some upside while protecting their downside.

"If you're not entirely sure, because you've been fooled by false breakouts too many times, then this is an alternative option," said Christopher Jacobson, co-head of derivatives strategy at Susquehanna International Group