A significant rally might be emerging in the often-overlooked sectors of the stock market.
On Monday, the small-cap Russell 2000 surged by 1.8%, reaching its highest level in two and a half years. This rise occurred amid signs of weakness in large-cap stocks and a shift away from 2024's biggest winners as markets brace for potential rate cuts.
Last Thursday, while the tech-heavy NASDAQ fell by 2%, the Russell 2000 climbed by 3.6%.
"Small caps are even more oversold, with valuations, whether you look at median P/E, now at 10 times 2025 earnings, being exceptionally low," Fundstrat's Tom Lee told CNBC. "We think this move could last around 10 weeks and reach as much as 40%. It appears to be just starting."
The June consumer price index report signaled the green light for the Russell 2000's rally, according to Lee, due to its "astonishingly soft" data. That month, inflation cooled more than expected, raising expectations that the Federal Reserve would cut interest rates by September.
Stocks in the Russell 2000 are typically more rate-sensitive compared to those in the S&P 500. Higher interest rates pose a challenge for the index, but it tends to rally when borrowing costs begin to decline.
"I think August will clearly showcase the rotation, with stronger performance from small caps and possibly flat or slightly down results for the S&P," Lee added.
When the Russell 2000 last experienced a rally of around 30% in the final months of last year, large caps similarly struggled, Lee noted. Given the current oversold state of small caps, the rotation could be even more substantial this time.
Concerns are mounting over the composition of major indexes, as a few tech mega-caps have driven the majority of gains this year. This narrow market concentration mirrors the previous bear market, according to Charles Schwab.
However, other analysts are also observing the growing appeal of small caps.
"This shift doesn't seem to be a 'one-off,' although it's too early to suggest we are witnessing a sustainable trend," Trade Nation's senior market analyst David Morrison wrote.
"Nevertheless, there is certainly a bullish interpretation to the rotation, as profits from 'overvalued' tech stocks are being redirected into more neglected areas of the US stock market," he added.
