In the first half of 2023, U.S. small-cap stocks showed decent trends but lagged the S&P 500 (up about 16%) and the Nasdaq Composite (up about 31.7%). The small-cap Russell 2000, an index tracking U.S. small-cap stocks, saw modest gains of around 7.2% during that period.

But Wall Street has seen a surge in small-cap stocks lately. This rally coincides with cooling inflation data and hopes of Fed rate cuts in 2024. Against this backdrop, Organogenesis ORGO, Riskified RSKD, Hooker Furniture Corporation HOFT, Stoneridge SRI and VirTra VTSI emerge as winning picks.

Below, we highlight a few reasons why small-cap stocks should soar higher in the coming days..

Decent U.S. GDP Growth

The U.S. economy expanded an annualized 4.9% in the third quarter of 2023, the maximum since the last quarter of 2021, above market forecasts of 4.3% and a 2.1% expansion in Q2, the advance estimate showed, per tradingeconomics. Consumer spending grew 4%, the most since Q4 of 2021, thanks to the consumption of housing and utilities, health care, financial services and insurance, food services and accommodations and nondurable goods (led by prescription drugs), recreational goods and vehicles.

A Dovish Fed Going Forward?

The latest datapoints indicate that inflation is on the decline. This may cause a less hawkish Fed in the near term. There is even a chance of a 75 bps rate cut in 2024.

Cheaper Valuation of Small Caps

Eric Green, CIO of Penn Capital Management, believes that the latest rally in small-caps has been long overdue, given the prolonged outperformance of large-cap stocks, as quoted on Yahoo Finance. Valuations for small-cap companies have become compressed relative to their larger counterparts, making them an attractive option for investors.

Small Caps: Key Beneficiary of Likely Fed Rate Cuts in 2024

Fundstrat's head of research, Tom Lee, also projects a small-cap rally in 2024, as quoted on Yahoo Finance. Lee indicated that small caps, which have more short-term debt than other companies, could benefit from the cost of capital coming down as the Fed is expected to cut rates in 2024.

M&A Activities to Pick up in Small-Cap Space?

Apart from reduced inflation, other factors are contributing to the rally in small-cap stocks. Per strategists, seasonality tends to benefit small caps toward the end of the year, making this an opportune time for their growth. Additionally, the valuation gap between large and small-cap companies, as well as private and public markets, suggests that merger and acquisition (M&A) activity may pick up. Companies may find it more attractive to acquire smaller, faster-growing firms, taking advantage of the valuation discrepancy.