Small caps have been all the rage on Wall Street over the past two months.
In fact, according to Bank of America's latest fund managers survey, investors haven't been this bullish on small caps in almost three years.
The survey conducted from Jan. 5-11 showed investors see large-cap companies underperforming small-cap companies in the next 12 months for the first time since June 2021.
Wall Street strategists believe the group of stocks — which investors often track by proxy using the Russell 2000 Index (^RUT) — has become increasingly attractive as the prospect of lower interest rates in the year ahead grows. Many see the small-cap index as undervalued compared to historical norms while also noting it hasn't fully joined the market rally as megacap tech stocks have.
In December, Fundstrat head of research Tom Lee noted that he sees megacap tech stocks still holding up well in 2024 but not outperforming small caps.
"I think small caps could rise 50% next year easily," Lee said. "And Financials (XLF) could rise 30% ... When it comes to positioning no one owns Financials and no one's really long small caps. There's a lot of upside."
But the market has shifted since Lee initially made his call.
Small caps have ripped higher amid the soft-landing-fueled rally, which has seen investors price in roughly six interest rate cuts in 2024 as inflation has fallen faster than many predicted.
It took just 48 days between late October and mid-December for the Russell 2000 to rise from a 52-week low to a new 52-week high, marking the fastest turnaround for the index ever, per Bespoke Investment Group.
Now, with the index up over 16% since its October lows, the key question for investors is whether the index has already priced in the future benefits of lower interest rates, limiting the upside in buying small caps.
Goldman Sachs, for its part, says no.
"The combination of low current valuations and a healthy economic outlook implies that the Russell 2000 should return roughly 15% in the next 12 months," Goldman Sachs's equity strategy team led by David Kostin wrote in a note to clients on Jan. 12.
A key caveat to this call could be if "investor expectations for economic growth deteriorate."
Lori Calvasina at RBC Capital Markets has also been recommending small-cap stocks for months.
Much of Calvasina's case for why small caps could outperform remains intact. That is: Small-cap stocks have outperformed in prior interest rate cutting periods — and their exposure to higher interest rates wasn't as bad as feared.
But a key part of Calvasina's call, that small caps had been oversold, has flipped amid the recent market rally.
This has Calvasina "concerned" about how popular small caps have become.
"In December it felt like everyone we met with (including the many varieties of investors who are not focused on Small Cap investing) wanted to talk about Small Caps and was constructive on them," Calvasina wrote in a note on Jan. 8.
She added, "We can’t remember the last time this happened."
Josh Schafer is a reporter for Yahoo Finance.
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