Could small companies post the biggest gains this year? That’s the hypothesis floated by Tom Lee of Fundstrat, as his prediction calls for small-caps to stage an epic comeback and the Russell 2000 to break above 3,000 for the first time ever.

It’s an interesting time to make that call, as the U.S. government just averted a shutdown until October. This involved passing a $1.2 trillion funding bill, so don’t be too shocked if government print-and-spend policy results in another wave of high inflation.

This is at odds with the Federal Reserve’s stated objective of achieving a 2% inflation rate and thereby having an excuse to lower interest rates in 2024. That’s a prime directive during a crucial election year, but recent strength in gasoline, oil, and copper prices indicate higher-for-longer inflation and, hence, higher-for-longer interest rates.

Nevertheless, Federal Reserve officials signaled three rate cuts in 2024 in their “dot plot,” so that’s the working theory for the time being. With that in mind, Lee is all in on small-cap stocks, saying, “With the Fed doing a dovish pause and CEOs getting more confident… I do think the Russell can rise 50% this year.”

Courtesy: MarketWatch

The market’s immediate response to last week’s Fed meeting seems to confirm Lee’s idea. On Wednesday, the Russell 2000 index outperformed the S&P 500 and had its best single-day advance in over a month.

Yet, that’s only a short-term market reaction. Could small-cap stocks really surge 50% in 2024, as Lee proposes they will? That’s ambitious, but anything’s possible on Wall Street and sometimes, lagging market sectors can become leaders.

There may actually be a valuation-based argument to support the outperformance of small-caps, or at least some of them. According to Lee, small-cap companies that are reliably profitable are valued at 11 times earnings. From a valuation standpoint, those companies are a bargain when compared to the S&P 500, which trades at 21 times earnings.

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    Furthermore, if history provides any clues, then the smart money should be on small-caps now. After stocks recovered from the bursting of the dot-com bubble in 2000, small-caps outperformed large-caps for years.

    Could something similar happen in the coming years? Lee seems to believe so, as he assured, “I think the Russell 2000 represents the best of things that happen when the Fed starts cutting.”

    Courtesy: @crofin67

    I might want to replace “the Russell 2000” in that statement with “small caps” and, more specifically, “small-cap gold stocks.” Check out the divergence between the rising gold price and the falling valuation of junior gold miners; the alligator’s jaws are open wide, but I expect them to shut in the near future.

    How is this divergence possible? Central banks are buying physical gold, with much of that activity coming from China. The demand hasn’t yet translated into higher prices for gold-related stocks, but that’s a lag that shouldn’t persist for too much longer.

    In other words, Lee could be right about small caps zooming higher, but I’m not betting on just any group of small caps. Investors who pick the right ones in the right sectors will be richly rewarded, not just in 2024 but for years to come.

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