The Russell 2000 index has broken historical records, and the 2,500-point target is just around the corner.

Higher-risk stocks have taken center stage, with the Russell 2000 index poised for its first record close in three years. This rebound was overdue and has the potential for further gains.

Despite ultimately ending flat, the Russell 2000 came close to the November 2021 peak of 2,442.74 points for part of Monday, having initiated a breakout last week. November closed with an 11% gain, outperforming the S&P 500 and the Nasdaq Composite. Strong U.S. economic growth, reasonable valuations, and expectations of interest rate cuts suggest that the 2,500-point barrier for this index should be within reach.

Small-cap stocks have recently benefited from Trump's election as president, reinforcing the 'America First' ideology. About 80% of the revenue of companies in the Russell 2000 index comes from domestic operations, and Trump's anti-trade stance and dollar-dominated policies have boosted investor sentiment towards this sector.

The rationale for breaking through the 2,500-point mark comes from a report by Oanda broker on Monday morning, which Kelvin Huang referred to as 'the key mid-term resistance for E-mini Russell 2000 futures.' This point is often seen as a psychological barrier in technical analysis, typically indicating an expectation of trend formation.

The driving force behind the rise of small-cap indices seems stronger than the resistance. The Russell 2000 is currently experiencing its third-longest period without a record close in history, while the S&P 500 has set 54 record closes this year.

Optimism also stems from expectations of interest rate cuts, which are crucial for small businesses. Due to their high debt characteristics, small businesses rely more on low interest rates to manage spending. According to data from CME Group, the market broadly expects the Federal Reserve's benchmark interest rate to drop to a range of 3.75% to 4% by 2025. Morgan Stanley expects rates to fall to a range of 3.5% to 3.75%, while Goldman Sachs predicts a final target range of 3.25% to 3.5%. Deutsche Bank is an exception, expecting only a 0.25 percentage point cut, from the current 4.5%-4.75% to 4.25%-4.5%.

If the interest rate cuts exceed expectations, small-cap stocks, being more sensitive to interest rate changes, will outperform the large-cap market. According to UBS analyst Jonathan Golub's report on Monday, over the past year, when expectations for rate cuts have risen, companies in the Russell 2000 index that are profitable had an average daily return of 0.21%, while unprofitable companies had a return of 0.44%. In comparison, S&P 500 companies had an average return of 0.16%.

Although the expected interest rate cuts for 2025 have not yet materialized, the optimism for economic growth next year is already strong. Forecasters surveyed by the Philadelphia Fed expect an economic growth rate of 2.2% in 2025, slightly below 2.7% in 2024, but still robust. Lower interest rates and strong economic growth create an ideal environment for small-cap stocks, as they are more sensitive to economic conditions.

Investors can also find some comfort in JPMorgan's report on Monday, which mentioned that the company still maintains an overweight position in U.S. small-cap and mid-cap stocks, partly due to 'increased demand for the U.S. market and a lack of upside potential for U.S. large caps at current valuation levels.' Goldman Sachs shared a similar view last month.

Currently, the price-to-earnings ratio of the iShares Russell 2000 ETF is 27.23 times, compared to 28.25 times for the iShares S&P 500 Growth ETF, which primarily invests in large companies.

The iShares Russell 2000 ETF has performed well recently, rising 20% this year, although growth funds have risen 38%, and the broader market (as measured by the SPDR S&P 500 ETF) has increased by 28%. Next year could be even better.

Article reposted from: Jin Shi Data