The Fed has officially embarked on its quest for the holy grail of monetary policy… 

Having slain the inflation monster with restrictive rates of 5.5% (or so they say) they must now start easing off the brakes so the rest of the economy doesn’t sputter and die.

The problem is, as Chairman Powell has admitted over and over, they have no idea what “neutral” actually is. (But they assure us, they’ll know it when they see it.)

And despite not knowing where they’re headed, they launched their effort by slashing their target rate by 50 basis points. Pretty much as large as they could go without sparking some panic in the market. 

The market, which had been in a solid uptrend since the low in October 2022, driven largely by mega-cap AI stocks, celebrated by continuing its rally. 

This policy reversal by the Fed is something the market has been anticipating for some time. And now that the easing cycle is underway, it should continue to please those big players driving the market.

But it should also benefit another segment of the market that has been lagging. And that creates an opportunity for investors…

Rise of the Small Caps

Since the low in October 2022, small cap companies have lagged the bigger players in the market. Take a look at the chart below…

S&P 500 vs Russell 2000

You can see tightly related performance of both the S&P 500 (an index dominated by mega-cap companies) and the Russell 2000 (an index of small-cap companies) into the 2022 low. 

Once mega-AI stocks began to drive the rally, the bigger better capitalized stocks took off. Smaller cap stocks, on the other hand, struggled to keep up lagging by over 20%.

That’s one sector that had been significantly impacted by the Fed’s tightening cycle. Now that’s very likely to change.

Why Small-Caps Love Lower Rates

Small cap companies are typically more sensitive to interest rates. One reason is that they tend to be more reliant on external financing to fund their operations and growth. 

Huge companies like Alphabet, Amazon, Microsoft all have massive cash reserves they can fall back on to fund their strategic plans. Tens of billions have been spent by big tech from their war chests on AI development. 

But many smaller companies, companies with market caps in the lower billion dollar range, don’t have that kind of financial ammo. They have to keep their eyes on operations. That means strategic borrowing is much more critical when it comes to things like financing growth and innovation.

Another reason is bottom line profitability. 

Smaller-cap companies generally have smaller profit margins than their bigger capitalized cousins. And a higher cost of capital (what they pay to borrow) tends to take a significant bite out of their already-thin bottom line.  

With the Fed moving to ease, lower financing costs will ultimately boost many small-cap companies’ bottom lines making them more profitable companies.

And of course, that leads to a third factor in bolstering the fortunes of the small-cap crowd — more profitable companies are more attractive to investors.

Lower interest rates, from an investor perspective, tends to generate what’s known as a “risk on” investment environment. One where funds and other institutional investors will leverage their portfolios by borrowing money to invest in companies they feel have potential for significant returns. 

And companies that have the potential for significant returns? Well they’re generally the ones that are undervalued or have been lagging the broader market. 

Right now, that’s the small cap sector. 

Looking at the chart above, the small-cap sector as a whole has significant room to actually outperform larger-cap competitors. 

Some small caps will do better than others. But right now may be the time for savvy investors to start scanning the small-cap universe for significant opportunities.