Small-caps are dominating the market. The Fed outlook explains why.

Happy Wednesday! The Dow notched another record Tuesday and the S&P 500 climbed 0.64%, but most of the Big Tech names we know and love were left on the sidelines for the rally.

The market laggards of the year have staged a recent comeback. The Dow is up 4% in the last week, while the tech-heavy Nasdaq has seen a paltry 0.4% gain by comparison.

The stars of the show, of course, have been small-cap stocks.

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It's a small-cap world

Small-cap stocks have been neglected all year , but they now have Wall Street’s full attention.

The Russell 2000, an index that tracks small-cap names, climbed a blistering 3.33% on Tuesday.?

It marked the fifth consecutive trading session where the group notched at least a 1% gain.

According to Ryan Detrick, chief market strategist for Carson Group, that’s only happened three times since 2000 — April 2020, September 2009, and January 2000.?

Meanwhile, Big Tech stocks like Nvidia and Microsoft moved in the opposite direction Tuesday.

Get this: The Russell 2000 is up 12.27% year-to-date, but more than 92% of those gains have happened in the last week.

As the chart shows, you can see a sharp rally starting July 9.?

The timing of this rotation from Big Tech into small-caps may have come as a surprise, but the fact of the shift is not such an anomaly.?

Investors are piling into corners of the market that are set to benefit from Fed rate cuts and the still-growing economy.

Generally, smaller companies perform better when monetary policy is less restrictive. They also tend to be more sensitive to changes in interest rates, as they take on heavier debt loads.?

And just about everyone — including Jerome Powell — expects rate cuts sooner than later.?

Currently, markets see five or six moves lower over the next year, per CME’s FedWatchTool. A September cut has been chalked up as a given.

Speaking Monday in Washington DC, Powell suggested that the Fed doesn’t plan to hit its 2% inflation target before lowering rates.

“If you wait until inflation gets all the way down to 2%, you’ve probably waited too long , because the tightening that you’re doing, or the level of tightness that you have, is still having effects which will probably drive inflation below 2%,” he said.?

Comments like that have fueled optimism for names in the Russell 2000.?

Zooming out, there have only been two periods in the last 25 years where the Russell 2000 has outperformed the tech-heavy Nasdaq:?

• The popping of the 2001 tech bubble
• The retail investor mania of 2021?

Both times were more extreme than what has unfolded so far in July, according to DataTrek Research.?

But neither setup is relevant today, in the firm’s view. Just like small-cap stocks, Big Tech names also benefit from rate cuts and a still-growing economy.

Plus, there’s no sign yet that a market crash is coming for mega-caps despite the recent sell off.?

For what it’s worth, the S&P 500’s equal-weight index has gained almost 4.8% in the last week, more than double what the benchmark S&P 500 has seen.

Taken together, the set-up should prevent any lasting outperformance of small-caps before 2025.

“For the moment, small caps have the better momentum because money managers cannot afford to stay as underweight as they have been forced to be over the last 18 months,” DataTrek co-founders Jessica Rabe and Nicholas Colas said.

“Once their re-weighting is done, the S&P should be able to play catch up.”

What do you think will perform better for the rest of the year, the Russell 2000 or S&P 500? Leave a comment below.

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