The Federal Reserve's interest rate cut brings a tailwind, small-cap stocks return to market focus, staging a main upward wave in the "post-giant era."

According to the Zhitong Finance APP, during most of the record-breaking surge in the U.S. stock market, small-cap stocks seemed to be on the sidelines. Especially during the strong upward periods when the U.S. stock market benchmark—the S&P 500 index—set new highs repeatedly this year, the small-cap benchmark, the Russell 2000 index, failed to continuously reach historical highs like the S&P 500 index. Now, under the significant boost of rising expectations for Federal Reserve interest rate cuts, the market's "animal spirits" have fully returned, and they have finally briefly joined this investment feast recently, almost ending the prolonged period of underperformance against the S&P 500 index since the COVID-19 pandemic.

During Wednesday's trading session, the Russell 2000 index rose 2.1% to 2453.36 points at one point, surpassing its historical closing high for the first time since November 2021, before giving back some gains and retreating from that level. The index ultimately closed up 0.2%. Although the index still failed to break through the historical high set in November 2021, the brief surge following the Federal Reserve's announcement of a 25 basis point rate cut, along with its recent outperformance against the S&P 500 index driven by expectations of rate cuts, indicates that the market is increasingly favoring small-cap stocks in the context of rate cuts.

So close to success—the Russell 2000 index had surpassed its historical closing high before giving back gains.

The rate cut, which had already been fully priced in by the market, pushed the Russell 2000 index higher, even though the broader U.S. stock market closed lower that day. Federal Reserve policymakers decided to lower the benchmark interest rate by 25 basis points in the early hours of Thursday Beijing time, and after months of strong pressure for rate cuts from the Trump administration, the FOMC's dot plot indicated that the Federal Reserve initially plans to cut rates two more times in the remaining months of this year.

This was the Federal Reserve's first rate cut in nine months, and both the magnitude and timing of the action were undoubtedly in line with market expectations. The market's focus was on the FOMC dot plot, which indicated that the median value of rate forecasts suggested the Federal Reserve would cut rates three times this year, one more than the last FOMC dot plot, with an additional cut expected next year. After the Federal Reserve announced its rate cut decision, Nick Timiraos, a prominent journalist for The Wall Street Journal known as the "Fed whisperer," stated that concerns about a slowdown in the labor market had completely overshadowed worries about inflation, providing justification for the Federal Reserve's shift to modest rate cuts, with its policy stance moving towards broader concerns about cracks in the labor market.

Additionally, in the policy statement following the rate cut announcement, the Federal Reserve did not reiterate, as it did last time, that the unemployment rate in the U.S. remains low, the labor market is robust, and inflation is still somewhat elevated. Instead, it removed the phrase about the labor market being robust and added expressions about slowing job growth and a slight rise in the unemployment rate, stating: job growth has slowed, and the unemployment rate has slightly increased but remains low; the inflation rate has risen and is still somewhat elevated. This modification in the statement signifies the official start of a new round of rate cut cycles by the Federal Reserve This statement reiterates that the Federal Reserve's FOMC monetary policy committee focuses on the two-sided risks it faces in achieving its dual mandate of maximum employment and price stability, while also adding the judgment that the risk of employment downturn has increased. The statement reads: The committee is concerned about the risks to its dual mandate and judges that the risk of employment downturn has increased.

The Russell 2000 Index is expected to enter a trajectory of continuous new highs and lead the market rebound

For investors who favor small-cap stocks, the past few years have been very challenging, as these stocks have not been able to follow 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 factors" seem to be showing a comprehensive return, and thus the stocks with the highest market risks are finally seeing increasingly strong long-term bullish momentum.

As market expectations for Federal Reserve interest rate cuts continue to heat up, investor sentiment towards small-cap stocks has begun to become more optimistic. 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 improvements in the macro environment and expectations for a turning point in monetary policy easing, investors are beginning to prepare for a potential style rotation, shifting from the hot but historically high-valued tech giants to undervalued small-cap stocks with solid fundamentals.

The so-called "Magnificent Seven," which occupy a significant weight (about 35%) in the S&P 500 Index and the Nasdaq 100 Index, includes: Apple, Microsoft, Google, Tesla, Nvidia, Amazon, and Facebook's parent company Meta Platforms, which are the core drivers of the S&P 500 Index's continuous new highs.

Undoubtedly, according to historical patterns, the restart of the Federal Reserve's interest rate cut cycle is initially favorable for small-cap stocks. If the Federal Reserve's interest rate cut cycle officially begins and the U.S. economy demonstrates resilience to achieve a "soft landing," the upward momentum of U.S. stocks is likely to continue rotating to those small-cap stocks that have suffered long-term price declines since 2022. From an investment theory perspective, these stocks are extremely sensitive to interest rate expectations, and even a slight rate cut is expected to boost their battered prices and valuations, especially for high-quality small-cap stocks supported by performance.

Therefore, some Wall Street analysts believe that the Russell 2000 Index is likely to enter a trajectory of continuous new highs similar to that of the S&P 500 Index this year and lead the overall market rebound.

A study by Bank of America, a major Wall Street firm, shows that under the macro backdrop of the Federal Reserve initiating interest rate cuts, small-cap stocks may significantly outperform the seven major tech giants of U.S. stocks and the broader large-cap stocks. The main logic is that small-cap stocks are often very sensitive to the benchmark interest rates set by the Federal Reserve; they heavily rely on floating-rate loans, so in the context of Federal Reserve interest rate cuts, it means that their long-standing debt pressure will be significantly reduced, which is expected to improve profit margins and stock valuations According to the Bank of America strategy team, small-cap stocks exhibit a stronger "spring effect": the lower they are pressed in the early stage, the greater the rebound potential in the later stage. Bank of America's long-term forecast indicates that small-cap stocks are expected to outperform the large-cap stocks dominated by the seven giants in annualized returns over the next decade. If the U.S. economy avoids recession in the next 12-24 months and interest rates enter a downward trend, small-cap stocks may welcome a "double rise" in profits and valuations, known as the Davis double play, as the market enters the "post-giant era" (where the rally of large-cap stocks dominated by the seven giants gradually gives way to high-quality emerging small-cap forces), with cumulative excess returns expected to significantly exceed those of large-cap stocks.

"A few months ago, small-cap stocks looked like they were on their last legs," said Irene Tunkel, Chief U.S. Equity Strategist at BCA Research. "Small-cap stocks are indeed cheap and have long been overlooked, but they have built up momentum for a significant rebound. Coupled with expectations for the Federal Reserve to ease monetary policy, new tax cuts from OBBBA, and brighter earnings expectations, this rebound suddenly gained strong momentum."

A brief but new record marked a stunning return for the Russell 2000 Index. Since the low in April, the index has rebounded over 36%, at which time the market was in a state of panic over Trump's aggressive "liberation day" tariff policy aimed at the world, and expectations that the "America First" agenda would drive a recovery in small-cap stocks fell short.

"The recent significant rebound in small-cap stocks aligns with a rise in risk appetite and the market's expectation that the Federal Reserve may cut interest rates three times this year," said Doug Beath, Global Equity Strategist at Wells Fargo Investment Institute.

Steven DeSanctis, an equity market strategist at Jefferies, pointed out that the macroeconomic backdrop is very favorable for small-cap stocks, and the second-quarter earnings data for the small-cap sector also exceeded general market expectations.

"Second-quarter earnings for small-cap companies were quite good, surpassing our expectations; and the market expects that later this year or next year, the earnings growth of small-cap companies will exceed that of large-cap stocks and the 'Magnificent Seven'," DeSanctis stated.

Michael Casper, a strategist at Bloomberg Intelligence, noted that the revenues of small-cap stocks are gradually approaching those of their large-cap peers in the market, and overall sales are expected to eventually surpass the peak levels of 2022, indicating that small-cap stocks still have further upside potential.

"If the Federal Reserve's interest rate cuts successfully stimulate a soft landing for the economy, the current market expectations for revenues may be too low, which would give the Russell 2000 Index the opportunity to ultimately outperform large-cap stocks," strategist Casper wrote in a report released on September 11.

Rising expectations are expected to boost the rally of small-cap stocks

The Russell 2000 Index was close to ending its record-breaking "drought of gains" by the end of 2024, but soon after, it plummeted due to concerns over tariffs. Since the last record in November 2021, other U.S. stock benchmark indices have set dozens of historical highs, especially the S&P 500 Index, which has set over 20 new highs this year, but the Russell 2000 Index has consistently failed to reach a new historical high In recent weeks, the bullish momentum in the market has significantly upgraded, and strategists are generally gradually turning optimistic about small-cap stocks. The Goldman Sachs strategist team led by David Kostin believes that expectations of interest rate cuts and a rebound in corporate earnings will spread this record-breaking rally to small-cap stocks and other "long-neglected areas."

At the same time, Michael Wilson, Chief Equity Strategist at Morgan Stanley, pointed out that there is still considerable room for catch-up in interest rate-sensitive sectors like small-cap stocks. After Federal Reserve Chairman Jerome Powell released dovish signals at the Jackson Hole meeting in August, Bank of America and UBS also joined the camp of long-term optimism for small-cap stocks to outperform.

"I really think the 'animal spirits' are starting to rise," DeSanctis said, noting an increase in merger and acquisition activity as the market has moved past most tariff concerns and pessimistic narratives, while regulatory easing begins to have a positive impact. "There are also more secondary IPO activities. Overall, the rebound in capital market activity is a good thing for small-cap stocks."

Finally, the rising expectations for interest rate cuts have helped the Russell 2000 index challenge its previously unattainable historical high. Since about half of the components in this index are not yet profitable, lower interest rates provide a strong boost for this highly leveraged group.

"Interest expenses account for a significant portion of small-cap earnings, and lower short-term rates will help alleviate this burden significantly," Beath from Wells Fargo Investment Institute stated.

Although interest costs may decline, Beath also cautioned that "lower-quality" small-cap stocks are more susceptible to the friction brought about by Trump's tariff agenda, as they have thinner profit margins and weaker supply chain resilience. Based on this, Beath continues to prefer large-cap and mid-cap stocks in the U.S. and maintains a cautious view on small-cap stocks.

At present, small-cap stocks are undoubtedly enjoying the continuous shine of "bullish sunshine," but how long their trend of outperforming the market can last remains uncertain. Kostin from Goldman Sachs stated that small-cap stocks still have better performance momentum in the short term, but he does not believe this trend will continue over the next 12 months.

For Tunkel, Chief U.S. Equity Strategist at BCA Research, small-cap stock valuations remain attractive, but "unignorable" headwinds still exist. "The rebound is impressive, but many small companies are facing rising costs and narrowing profit margins, which could make this rally fragile," Tunkel said