July marked a significant market rotation, with investors flocking to small-cap stocks anticipating that the Federal Reserve’s expected interest rate cuts would make borrowing cheaper for smaller companies.

This strategic pivot led the iShares Russell 2000 ETF IWM to experience its best monthly performance against the Nasdaq 100, represented by the Invesco QQQ Trust QQQ, since April 2002.

This month, the Russell 2000 rallied by a robust 9.2%, while the Nasdaq 100 fell by 5%, resulting in a 14% relative outperformance of small caps over tech stocks as of July 30.

Chart: Small Caps Sharply Outperformed Tech In July, Notch Strongest Month Since April 2002

Small Caps Set To Beat Big Tech This Year? What Needs to Happen

Year-to-date, small caps are nearly flat compared to tech, after effectively closing a wide gap.

Over the past 12 years, the Russell 2000 has outperformed the Nasdaq 100 in calendar years only three times: 2013 (+1.3%), 2016 (+13%), and 2022 (+17%).

The July rotation could extend further if the Federal Reserve implements expected interest rate cuts.

The best-case scenario for small caps involves robust economic growth mitigating recession fears, evidenced by the recent 2.8% growth in the second quarter of 2024 by the the U.S. economy, along with easing inflationary pressures, which could prompt rate cuts not tied to a slowdown.

Quincy Krosby, chief global strategist for LPL Financial, highlights that the prospect of interest rate cuts has driven a surge in smaller stocks, which are more sensitive to interest rate changes than the S&P 500, especially compared to mega-tech names.

Krosby suggests the continued investment in small-cap stocks indicates investor confidence in a strong economic backdrop and anticipated lower interest rates.

Read Also: Investors Go All In On Small Caps, Pour Over $6 Billion Into Russell 2000 ETF This Month: They ‘Will Return To Larger-Cap Alternatives,’ Veteran Analyst Says

“There has been a prevailing concern that because small caps require a solid economic landscape, a weaker U.S. economy could easily hinder investor interest,” Krosby warns.

Starting in September, market participants expect a rate cut, with a 90% probability of a 25-basis-point reduction and a 10% chance of a 50-basis-point cut, according to the CME Group FedWatch Tool.

The federal funds rate is projected to be reduced again in November and December, potentially ending the year between 4.5% and 4.75%. Additional cuts are expected in the first half of 2025.

If the Fed proceeds with this rapid and steady pace of rate cuts, small caps could continue to rally due to their sensitivity to broader borrowing costs in the economy.

Russell 2000’s Historical Performance In Presidential Election Years

Bank of America analyst Stephen Suttmeier, CFA, CMT, says the Russell 2000 established all-time highs in four of the last five presidential elections: 2020 (won by Joe Biden), 2016 (won by Donald Trump), 2012 (won by Barack Obama, second term), and 2004 (won by George W. Bush, second term). Small caps also displayed a bullish setup during the 1992 election (won by George H.W. Bush).

The experts suggests the 2024 pattern shows the Russell 2000 breaking out from a significant base, indicating that the 2024 Presidential election could also coincide with new all-time highs.

“An overbought condition is not necessarily bearish. The Russell 2000 had solid post-election rallies after the 2020, 2016, 2012, 2004, and 1992 Presidential elections, and they all started with overbought monthly momentum,” Suttmeier stated.

Chart: Russell 2000 Needs A +11% Rally To Achieve Record Highs This Year

Image: Benzinga Pro

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