Is a nearly 10% increase just an appetizer? Wall Street is optimistic that small-cap stocks can rise another 20%!

According to the Zhitong Finance APP, the Russell 2000 Index (which includes some of the riskiest stocks in the market) has recently surged, with several Wall Street strategists believing that this upward trend has only just begun.

As a key indicator of small-cap stock performance, the Russell 2000 Index has accumulated nearly a 10% increase since the end of July, which is double the increase of the S&P 500 Index. Compilation data shows that through bottom-up integration of analysts' target prices, analysts expect the "outperformance" of small-cap stocks to continue over the next year: the Russell 2000 Index is expected to rise another 20%, while the expected increase for the S&P 500 Index is 11%.

This prediction seems quite bold in the recent context. Since 2020, small-cap stocks have underperformed large-cap stocks each year; even with this significant increase, the cumulative increase of the Russell 2000 Index so far in 2025 is still less than that of the S&P 500 Index. However, the logic behind this prediction is clear: if the Federal Reserve starts cutting interest rates as expected, it will significantly reduce the financing costs for companies in the Russell 2000 Index, thereby significantly improving their profit margins. Analysts believe that the U.S. stock market bull run, previously driven mainly by large-cap stocks, will gradually expand into the small-cap sector under the support of the Federal Reserve's easing policies (which will maintain a robust economic operation).

Michael Casper, a senior U.S. equity strategist at Bloomberg Intelligence, pointed out: "These (small-cap) companies are the most sensitive to the U.S. economy, and interest rate cuts may become a catalyst to win more support for this sector from Wall Street. Suddenly, market consensus is starting to favor small-cap stocks."

The market's reaction to inflation and employment data on Thursday further confirmed this optimistic sentiment. The inflation data released that day was largely in line with expectations, and there were more signs showing that the labor market is cooling, which made investors more confident that the Federal Reserve will start cutting interest rates next week and will do so again later this year. As a result, the Russell 2000 Index rose by 1.2%, while the S&P 500 Index increased by 0.7%.

Michael Wilson of Morgan Stanley stated in a research report on Monday that the Federal Reserve's interest rate cuts could push the bull market into the "next phase" and drive small-cap stocks higher. Earlier this month, he upgraded his rating on small-cap stocks from "underweight" to "neutral," but also mentioned that he needs to see an increase in the breadth of earnings revisions for small-cap companies before fully turning to "overweight."

From the current earnings season's performance, small-cap stocks are moving in a positive direction. Data from Bloomberg Intelligence shows that over 60% of companies in the Russell 2000 Index exceeded earnings expectations for the second quarter of 2024, and overall revenue averaged 130 basis points above expectations.

Tom Hainlin, chief investment strategist at US Bank NA, stated in a phone interview: "The combination of earnings growth, the realization of interest rate cuts, and low valuations provides strong support for the rise of mid and small-cap stocks." Goldman Sachs Chief U.S. Equity Strategist David Kostin also expressed a similar view.

Emily Roland and Matt Miskin, Co-Chief Investment Strategists at Manulife John Hancock Investments, pointed out that small-cap stocks have been "undervalued" this year—"almost all categories of stocks are valued above their 20-year average, except for U.S. mid-cap value stocks and small-cap stocks."

Jill Carey Hall, a strategist at Bank of America, stated that the rally since August has pushed the Russell 2000 index's price-to-earnings ratio slightly above its long-term average, but it has not reached a level that warrants concern. The Bank of America equity and quantitative strategist noted in a report on Monday: "Compared to historical levels, small-cap stocks are no longer cheap, but they remain the sector with the least valuation pressure, and relative to large-cap stocks, their valuations are still at historical lows, with significant discounts." She believes that small-cap stocks have "further revaluation potential."

The options market also shows that investors' confidence in the continuation of the rally in small-cap stocks is increasing. Data from the Chicago Board Options Exchange indicates that the options positioning for the Russell 2000 index is more bullish than that for the S&P 500 index.

Mandy Xu, head of derivatives market intelligence at the Chicago Board Options Exchange, explained: "This phenomenon makes sense—investors tend to buy hedging tools in areas where they have concentrated holdings (such as large-cap stocks) to mitigate risks, while they buy call options in areas where they are underexposed and see potential for catch-up (such as small-cap stocks)."

Lori Calvasina, a strategist at Royal Bank of Canada Capital Markets, pointed out that passive funds have begun to see net inflows into U.S. small-cap stocks. However, this U.S. equity strategist also warned that for small-cap stocks to continue rising, "there needs to be signs that the economy has emerged from the downturn and is starting to recover." Additionally, since the COVID-19 pandemic, small-cap stocks have experienced breakout rallies multiple times, but in recent years, they have been overshadowed by the performance of the technology sector and large-cap stocks.

Nevertheless, Barclays analysts still urged investors to prioritize technology and small-cap stocks in their research report on Wednesday, citing "their strong earnings momentum," and declared: "Small-cap stocks are facing a significant opportunity."