Many investors were anticipating small-cap stocks would outperform coming into 2024, saying the prospect of easing monetary policy introduced by Federal Reserve Chair Jerome Powell at the end of last year would be a boon for the interest rate-sensitive asset class. Instead, small caps spent the first half of this year doing what they have been doing for the past decade: falling behind. While the S & P 500 surged to all-time highs this year on the strength of a handful of artificial intelligence stocks, the small-cap Russell 2000 has spent the past six months treading water. But now, there finally appears to be a breakout. In July, the Russell 2000 rallied more than 9%. Meanwhile, the S & P 500 is flat on the month. .RUT YTD mountain Russell 2000 year to date An improvement in the interest rate outlook, as well as inflation, spurred the small-cap rally, as investors bet on the asset class like they haven't in a long time. These investors expect that a historically wide valuation gap, a pickup in merger and acquisition activity plus long-term reshoring trends are supportive of a multiyear shift in performance for the asset class. "This breakout only tells me that finally you're gonna get some rational investors back in the markets," said Nicholas Galluccio, portfolio manager at the Teton Advisors. The manager said his fund, the TW Smallcap Equity Fund Class I, rallied along with the market. As of Wednesday, it is up 11.37% this year. The Russell 2000 Value was up 10%, with the Russell 2000 having gained 11%. A sustainable rally Small caps have underperformed for roughly the past decade, but they have typically done better historically. One stock pricing model often cited is the Fama French 3-factor model , which found that since 1927, small caps have outperformed large caps by two percentage points each year. "It's been a tough run for small caps. You've seen the 'Magnificent Seven' kind of suck up all the air out of the room, both in terms of attention, but also in terms of investor flows into the asset class. Some analysts I've seen say this is the longest period of underperformance ever," said American Century Investments' Mike Rode. But Rode added, "It is cyclical over time, though." Rode anticipates that this outperformance could last some time, anywhere from a period of 12 to 24 months. Meanwhile, Teton Westwood's Galluccio thinks it can last much longer. "I think small caps stand to outperform for the next three years," Galluccio said. A lift from onshoring But there are other reasons for adding to the bull case in small caps. Onshoring of supply chains from abroad amid rising geopolitical tensions — particularly for semiconductor companies and pharmaceuticals — is anticipated to support small caps that are typically domestically focused. As an example, Rode pointed out that an electric vehicle battery plant for Panasonic in De Soto, Kansas, can boost the bottom lines for small-cap companies contracted for the construction of buildings and roads, as well as regional banks that help finance these projects. SUM YTD mountain Summit Materials year to date Summit Materials , a construction materials company, is one such stock that can benefit from reshoring projects. The stock is up just 2% this year. Analysts polled by LSEG consider it a buy. Similarly, Teton Westwood's Galluccio is invested in wafer handling company Cohu , which he said is cheap, has earnings power, no debt and ample cash on its balance sheet. "Those are the kinds of companies we're looking at," he said. Cohu shares are down roughly 10% this year, but the stock is considered a buy, according to the LSEG consensus estimate. COHU YTD mountain Cohu shares year to date Other trends that should boost small caps include a steepening yield curve , as well as a pickup in merger and acquisition activity. There is a risk inherent in small-cap investments as they are less liquid and more tied to the economy than their large-cap peers. However, investors can try to avoid those pitfalls by investing in quality companies with strong balance sheets and high returns on capital. "The last decade was the first time in many, many years when small caps underperformed, leading the talking heads to say that quality, quality, quality is large-cap growth. Well, guess what? Quality can also be small cap," Galluccio said.
