Small-Cap Stocks Are on a Roll. What Could Push Them Higher.

Small-cap stocks have risen more than 9% since the beginning of August. (Angela Weiss/ AFP / Getty Images)

Small-cap stocks have finally had their day in the sun. They could keep shining if a few factors go their way.

The Russell 2000 , which has an average market cap of $4 billion, has jumped just over 9% since Aug. 1, after the market had finished digesting additional U.S. tariffs. Over that span, small-caps outpaced the S&P 500 ’s 4% rise.

That’s because the economic picture is shaping up just right for small-caps: The Federal Reserve will likely lend the economy a hand and lower interest rates next week. Small-caps tend to see an outsize earnings boost versus larger firms when the economy grows.

The Russell 2000, at around 2400 currently, has already priced in much of this picture. Now, the index is closing in on resistance levels. That means small-caps will need another catalyst to continue outpacing the S&P 500 and its megacap tech stocks.

That catalyst could be none other than the Fed, but not just a simple rate cut. If the central bank says anything that strongly indicates it could reduce interest rates again in the winter, it would boost economic forecasts even further—another boon to small-caps’ profits.

Morgan Stanley’s chief U.S. equity strategist, Mike Wilson, recently upgraded small-caps precisely because he believes the Fed will eventually cut several times, likely next year—catalyzing more small-cap outperformance, even if not quite yet.

Another positive driver could be higher analyst earnings estimates, which small-caps will need to see eventually. Expected earnings and the level of the Russell 2000 are highly correlated, but recently, the index has risen faster than those estimates.

The index’s aggregate expected earnings for the coming 12 months sit around $250 a share, which should correlate to the Russell 2000 trading several percentage points lower than its current level, according to Wilson’s data. But if the U.S. economy does reaccelerate, or these smaller companies’ third-quarter earnings surpass estimates this fall, analysts could revise their estimates higher, justifying the Russell 2000’s current level.

Those upward revisions to small-caps’ profit estimates could come soon. Only about half of all 2026 revisions for the Russell 2000 have been upward, according to FactSet, compared with close to 60% for the S&P 500. Small-cap revisions would eventually catch up if the economy remains strong.

“We still have yet to see relative earnings revisions breadth for small-caps turn higher—a development worth waiting for,” writes Wilson.

Of course, the risk to this picture is that a Fed cut this winter isn’t a shoo-in. Inflation is still a bit above the Fed’s 2% goal, and tariffs could prevent it from slowing to that level soon enough for the Fed to lower rates more than once this year. But what a welcome surprise multiple rate cuts would be for the market.

“Given the risk that the Fed may still be focused on inflation more than the weakness in the labor market, rate cuts may materialize more slowly than is necessary to catalyze a durable rotation to lower quality small cap names in the near term,” Wilson writes.

Still, for anyone who believes in this economy in the long run**,** sticking with those smaller names makes sense.

Write to Jacob Sonenshine at jacob.sonenshine@barrons.com