Beaten-down small-cap stocks are roaring back. Why they could soar in 2024.

But small caps are playing catch-up after being left in the dust, with the Russell 2000 now up 15.5% for the year to date versus the S&P 500’s 23.8% gain.

Continuing the surge in small-cap stocks in 2024 will hinge on what the Fed does next with its key interest rate, analysts said.

See: The Magnificent 7 dominated 2023. Will the rest of the stock market soar in 2024?

Tom Lee, head of research at Fundstrat, is perhaps among the most bullish of the bulls. He expects small-cap stocks to climb as much as 50% in the next 12 months.

The Russell 2000 could reach as high as 3,000 by the end of 2024, Lee told CNBC in a recent interview. The Russell 2000 traded up 0.8% to 2,034 on Friday. Still, the index is over 16% below its record close in November, 2021.

“Investors in the next 12 months are going to see what things get fixed if the Fed just stops being so aggressive on rates,” Lee told CNBC. Small-cap stocks that are higher levered will benefit from the rate cuts, he noted.

To be sure, if the Fed keeps rate higher for longer, borrowing costs will remain elevated for companies that had grown used to the low-rate environment over a decade, which allowed even unprofitable companies to flourish.

Read: Investors kissed the era of cheap money goodbye. Now what?

Small-cap companies have been hit especially hard with higher interest expenses since 2022, as the Fed raised its key interest rate 11 times from close to zero to the range of 5.25% to 5.5%, a 22-year high.

Fed Chair Jerome Powell, however, also bolstered equity bulls at the central bank’s last policy meeting of 2023 by signaling a pivot to rate cuts was likely in 2024.

Small-cap companies are more sensitive to interest rates, as they tend to have weaker balance sheets, a higher percentage of debt and less fixed-rate debt, compared with their large market-cap peers. The average debt maturity for large-cap companies stands at roughly 11 years, versus 5.5 years for small-cap companies, according to Tom Hainlin, global investment strategist at Ascent Private Capital Management of U.S. Bank.

Read: ‘Magnificent Seven’ up for another bull run? What to expect from technology stocks in 2024.

Small cap catch up?

As the Federal Reserve signaled a pivot to rate cuts was likely in 2024, small-cap stocks are beginning to catch up. Traders are now pricing in a total of 150 basis points of rate cuts in 2024, with the first cut expected in March 2024, according to the CME FedWatch tool. That’s far more optimistic than the 75 basis points of rate cuts the Fed penciled in for next year.

Optimism about rate cuts has helped fuel the Russell 2000’s December rally. The small-cap barometer has outperformed the S&P 500 by 8.3 percentage points, putting it on pace for its best month versus the large-cap equity gauge since February 2000, according to Dow Jones Market Data. 

“When you started to see interest rates fall I think that sparked a pretty big reversal,” according to Zachary Hill, head of portfolio management at Horizon Investments. 

Gains for small-caps were also likely enhanced by low volume, which can make for exaggerated price moves, Hill said.

In the new year, the end of the rate-hike cycle, cooling inflation, a strong labor market and solid consumer spending could continue to boost small-cap performance, said Francis Gannon, co-chief investment officer at Royce Investment Partners.

Historical look

It’s time for small-cap stocks, which have been treading water in the past few years, to see a turnaround, Gannon wrote in emailed comments.

The Russell 2000 saw an annualized return of 2.4% for the five years ended Sept. 30, among the lowest five-year returns since the index’s inception, noted Gannon. However, the index has historically seen higher-than-average returns in the five years following a five-year period when it posted lower-than-average returns.

The small-cap gauge scored an average annualized return of 14.9% for the five years following a low-return period. That is well above the index’s monthly rolling five-year return of 10.4% since inception, according to Gannon. 

Jay Hatfield, chief executive at Infrastructure Capital Management, said he is especially bullish on small-cap value stocks in 2024. 

“A lot of them with dividend yields got thrown out with the bathwater when rates rose,” Hatfield said. Now it’s time for them to shine as rates are expected to fall, Hatfield noted. 

Hatfield expects the S&P 500 to rise by about 15% by the end of 2024, and small-cap stocks to gain more than 20% over the same period. 

See: What the stock market’s biggest bull expects in 2024. Fundstrat’s Lee reveals highest S&P 500 forecast on Wall Street.

Further evidence on a soft landing is required to support small-cap stocks’ continued rally, said U.S. Bank’s Hainlin. If the market sees a corporate profit recession or consumer contraction in 2024, there is potential for small-cap stocks to underperform, Hainlin said.

Horizon Investments’ Hill said it’s important to watch small-cap companies’ earnings in the first quarter of next year to gauge if the rally is sustainable. 

“For us, just having a portion of the equity market cheap is not enough to get bullish on something,” Hill said. 

“We would have to point to Q1 earnings season and the guidance there as a potential catalyst that could either confirm this rally that we’ve seen so far, or cause some investor repositioning towards the stuff that’s intended to dominate for the last year,” Hill said.