After lagging large capitalization stocks for months, small-cap stocks may be having a moment.

The S&P 600, an index of smaller-cap stocks, fell by just over 1% through the first six months of the year, while the large-cap S&P 500 rallied about 15.1%. From July 1 to July 16, however, the S&P 600 rose 10.3%, while the S&P 500 went up 3.5%. The Russell 2000, another index of small-cap stocks, increased 11.5% during the same period after rising just 1.7% in the first six months of the year.

"The outperformance here has been remarkable and indicative of institutional rotation into a group that had mostly been ignored year to date," said Bret Kenwell, a US investment analyst with eToro. "As confidence grows in the Fed's first rate cut, confidence is growing in small- and mid-cap stocks."

Small-cap stocks rallied substantially in July as inflation data has cooled and the prospects of interest rate cuts as soon as September have risen to a near certainty.

"We believe small caps are rallying as markets expect the Fed to start the rate-cutting cycle sooner rather than later," said Sonu Varghese, global macro strategist with Carson Group. "Small-cap companies tend to take on more floating-rate debt, and so lower rates are very helpful."

Playing catch-up

The market is playing a bit of "catch-up" with small stocks following months of speculation that persistent inflation could keep the Fed from cutting rates in 2024, Varghese said.

Large-cap indexes have also benefited from the significant gains of the mega-cap tech stocks, including Nvidia Corp., Microsoft Corp., Apple Inc., Amazon.com Inc., Meta Platforms Inc., and Alphabet Inc., said Philip Greenblatt, portfolio manager and senior analyst at Easterly Investment Partners.

"Over the last 10 to 15 years, the advent of passive investing and more quantitative-based models have led to higher correlations and lower dispersion in stocks with higher market capitalizations as broad-based flows move into and out of those names every day for little fundamental reason related to the specific group of stocks," Greenblatt said.

The "narrow breadth" in the large-cap index and historically high valuations should be a troubling sign for investors, Greenblatt said. With rate cuts nearing, small caps could be poised for a significant run of outperformance.

"I do think there's a case to be made that capital will flow back into smaller companies with great balance sheets, real free cash flow and reasonable valuations as money unwinds from this large-cap outperformance," Greenblatt said.