Small-Cap Stocks Poised for a Catch-Up Rally
Small-cap stocks look ready for a meaningful catch-up rally as interest rates drift lower. Sean Gallagher, who heads Lazard’s small-cap equity platform, sees the current setup as favorable for these companies and expects the backdrop to steadily improve if borrowing costs continue to ease.
His case is simple: the gap. Small caps have trailed large caps, and falling rates could be the spark that helps close that gap. Under today’s conditions, Gallagher argues, the runway for a rebound is in place—and the runway looks long.
A 30%–50% Move on the Table
Gallagher expects the small-cap universe, as tracked by the iShares Russell 2000 ETF (IWM), to rally roughly 30% to 50% over the next year. A move of that size would go a long way toward narrowing the performance spread versus bigger, more dominant equities. The anchor of his view is valuation—specifically, how cheap many smaller companies look next to their large-cap peers.
He points to what he describes as a notable and persistent disparity in pricing, one that he believes leaves room for a strong rebound if macro conditions break their way.
What the Valuation Gap Looks Like
The valuation gap between small and large caps is a key reason for optimism. On a median basis, and excluding companies that aren’t earning money, small caps trade around 9.5 times earnings. That’s a low bar. When you remove non-earners to make a cleaner comparison, the underlying small-cap index looks more attractive on valuation alone, Gallagher says. The takeaway: the gap is real, and it’s doing a lot of the work in this thesis.
Why Lower Rates Matter
Gallagher’s positive stance leans on an expected pivot by the Federal Reserve toward rate cuts. If the Fed begins to ease, that shift could be a clear catalyst for small caps to outperform larger companies. He’s confident inflation is cooling, and that trend—if it continues—could shape the Fed’s decisions in the near term and set the stage for a better small-cap backdrop.
In plain terms, cheaper money tends to help smaller firms more. Their fortunes are tied to financing costs, and rate relief can quickly flow through to earnings and sentiment.
Rate Cuts Could Hit Where It Counts
Forecasts calling for as much as 200 basis points of cuts within the year would be meaningful for small-cap balance sheets. Many small companies carry more leverage and are more sensitive to interest expenses than larger firms. Lower rates can reduce borrowing costs, ease refinancing pressure, and free up cash for hiring, investment, or debt paydown. That’s where the effect would likely show up first—and fastest.
Sectors Lazard Favors
Lazard’s approach highlights areas that tend to respond well when rates fall. Gallagher calls out financials, healthcare, and consumer durables as pockets of particular interest right now. In a falling-rate environment, those groups can benefit directly from cheaper capital and indirectly from a steadier economic pulse.
As conditions evolve, his team is focused on businesses positioned to translate lower financing costs into improved margins or renewed demand. It’s still the same theme: lower rates, smaller companies, closing the gap.
Healthcare and Consumer Durables: Where a Turn Could Start
Healthcare investment—especially in biotech—has been subdued, but Gallagher thinks lower borrowing costs could coax capital back into the space. If financing becomes more accessible, projects that were shelved or delayed may start to move again. Consumer durables could also get a lift, particularly for companies carrying meaningful debt loads. With interest pressure easing, balance sheets can breathe, and that relief can show up in operations and, eventually, results.
Politics in the Mix
Gallagher also weighs the 2024 U.S. presidential election and its potential effects on small caps. Historically, small-cap stocks have tended to do better under Republican administrations. Policies that lean toward lower taxes and lighter regulation could reinforce the small-cap recovery, should that policy direction prevail.
None of this is a verdict, of course. It’s a scenario. But it’s part of the mosaic investors are watching as they gauge what might narrow the gap.
Growth Hinges on Policy Direction
Analysts see a Republican-led administration as a possible tailwind for small businesses, especially if it brings tax reductions or deregulation. If those steps materialize, the setup could be constructive for small caps. That said, the election outcome will determine whether these potential supports move from idea to action.
Challenges Ahead: What to Watch
For all the positives, Gallagher is careful about the risks. Chief among them is timing—specifically, the risk that the Federal Reserve lags the slowdown. If policy support arrives too late, the economy could lose momentum before cuts can help. Early reads from consumer and industrial activity argue for cautious optimism, but the data still need to confirm the trend.
In other words, the gap can close—but it still depends on execution, timing, and a steady hand on policy.
Why the Fed’s Timing Matters
The Fed’s ability to move promptly could be pivotal in limiting any downturn before easier policy gains traction. Gallagher urges action that safeguards momentum and helps create the conditions for a durable small-cap rally. Get the timing right, and the gap can narrow. Get it wrong, and the gap can linger.
Frequently Asked Questions
What’s the main reason small caps could rally now?
The core driver is expected rate cuts. Lower borrowing costs typically help smaller, more rate-sensitive companies, which can translate into better earnings and improved sentiment for small-cap stocks.
How big is the potential move Gallagher envisions?
He sees room for a 30% to 50% advance in small caps over the next year, using the iShares Russell 2000 ETF (IWM) as a proxy. Such a move would help close the recent performance gap with large caps.
Why is valuation so important in this outlook?
Excluding non-earners, the median small-cap price-to-earnings ratio sits around 9.5 times. That relatively low multiple makes the asset class look appealing versus larger companies, supporting the catch-up case.
Which sectors stand out if rates fall?
Gallagher highlights financials, healthcare, and consumer durables. In a lower-rate environment, these areas can benefit from cheaper financing and steadier demand as conditions improve.
How might the 2024 election influence small caps?
Historically, small caps have tended to fare better under Republican administrations. If the election leads to lower taxes or deregulation, analysts expect that could be a tailwind for small-cap companies—though it ultimately depends on the outcome and policies enacted.
