Russell 2000 hits record high on Fed cut: does the small-cap rally have more legs?

US stocks extended their rally on Friday, with all major indices hitting fresh record highs following the Federal Reserve’s decision to cut interest rates.

The small-cap Russell 2000 index joined the broader market in scaling new peaks.

The Fed’s quarter-point rate cut on Wednesday, which lowered the federal funds rate to a range of 4% to 4.25%, was met with investor optimism.

Markets are now pricing in two additional cuts before the end of the year, creating a supportive backdrop for equities.

While the S&P 500 and Nasdaq Composite advanced, it was small caps that captured market attention.

The Russell 2000 has gained nearly 9% over the past month, outpacing the S&P 500’s 3.67% climb and the Nasdaq’s 5.9% rise.

Since bottoming out on April 8 amid tariff-driven market turmoil, the small-cap index has surged about 40%.

Catch-up trade underway

Analysts say the recent rally reflects a long-awaited catch-up trade for small caps, which have lagged behind large-cap peers for much of the past decade.

“Small caps have underperformed pretty dramatically over the last decade or so, and catch-up trade seems to be underway,” said Keith Buchanan, senior portfolio manager at Globalt Investments.

"We see the environment that we are in being conducive for the rally in small caps to continue," he said.

Buchanan added that President Donald Trump’s sweeping tax cut bill, passed in July, has given an added boost to domestically focused companies, which dominate the Russell 2000.

Fed policy and earnings prospects

Michael Reynolds, vice president of investment strategy at Glenmede, highlighted the Fed’s policy shift, the potential for earnings growth, and the valuation gap with large caps as key drivers of the small-cap rebound.

Small-cap stocks are generally more exposed to borrowing costs than large-cap peers, given their greater dependence on external financing.

While this makes them more vulnerable to economic slowdowns, it also creates a paradox: the very weakness that could push the Federal Reserve to cut rates further may simultaneously weigh on these rate-sensitive companies and other cyclical sectors of the market.

Still, Reynolds cautioned that the rally rests on a delicate balance.

"There's a narrow pathway where the labor market shows enough cracks to spook the Fed into cutting rates, but it doesn't necessarily spell the end to this [economic] expansion," Reynolds told MarketWatch.

Valuations remain relatively attractive

Despite recent gains, analysts say small caps continue to offer better value than large caps.

Data from Dow Jones Market shows the iShares Russell 2000 ETF trading at a forward price-to-earnings ratio of 24.5, compared with 22.41 for the iShares Russell 3000 ETF.

While that makes small caps slightly more expensive on an absolute basis, Reynolds argues they remain cheaper relative to fair value.

Glenmede estimates small-cap stocks are trading at a 2% premium, versus a 26% premium for large caps.

The resulting 24% valuation gap is far above the long-term average of 4%.

"Historically speaking, small caps are right about the 90th percentile of relative valuations," he added.

Value versus growth in small caps

Not all small caps are priced equally.

Joshua Schachter, chief investment officer at Easterly Snow, said value stocks within the Russell 2000 remain particularly attractive.

The iShares Russell 2000 Value ETF was trading at a forward P/E ratio of 18.18 on Thursday, well below its growth counterpart.

"The Russell 2000 Value is almost at the levels post-election in November," Schachter told MarketWatch.

"The Russell 2000 Growth is weighted more substantially with higher P/E stocks - so you're going to get higher valuations from the growth side, but the value side is much cheaper and the P/E ratio is much more attractive relative to the benchmarks," Schachter said.