My twin grandsons, age seven, give me immeasurable joy. I especially enjoy reading bedtime stories to them. Last night on the docket was the 1930 classic The Little Engine That Could, and it occurred to me that now’s an opportune time to write about small-cap stocks and their strong prospects for next year. (Seeing financial metaphors in everyday life is an occupational hazard.)

The definitions have shifted over time and vary depending on whom you ask, but here’s a general breakdown of the market valuation categories: mega-cap (above $200 billion); large-cap (between $10 billion and $200 billion); mid-cap (between $2 billion and $10 billion); small-cap (between $250 million and $2 billion); and micro-cap (less than $250 million). As a rule, I avoid micro-caps unless the opportunity outweighs the enhanced risk.

No matter where you draw the line, small caps offer a tantalizing benefit to investors: the prospect of higher returns than large caps. Small-caps tend to be riskier than their larger brethren, but the rewards can be greater, too.

Or as legendary Fidelity mutual fund manager Peter Lynch put it: “Big companies have small moves, small companies have big moves.”

A commonly used benchmark for small caps is the Russell 2000. This index reflects the performance of the smallest 2,000 companies in the Russell 3000, which consists of the 3,000 biggest U.S. companies, or roughly 98% of the investable U.S. equity market. The Russell 2000 comprises about 10% of the larger index’s market cap.

After a prolonged slump, small caps have been soaring in recent days, as evidenced by the upward momentum of the benchmark iShares Russell 2000 ETF (IWM). See the following chart, with data as of market close November 17:

The IWM has broken above its 50-day moving average and it’s knocking on the door of its 200-day moving average. A rising moving average indicates that the security or index is in an uptrend, while a declining moving average indicates a downtrend.

Accelerating economic growth is likely to provide a catalyst for small-cap outperformance next year. Historically, small-cap stocks have demonstrated a heightened sensitivity to economic conditions, flourishing during periods of expansion.

Smaller companies, often nimble and innovative, are better positioned to capitalize on new opportunities that arise with economic growth. Unlike their larger counterparts, small caps can swiftly adapt to changing market dynamics, allowing them to leverage emerging trends. This adaptability not only positions them favorably in a recovering economy but also enhances their growth potential.

Another factor bolstering the case for small-cap outperformance in 2024 is the high probability of a Federal Reserve interest rate cut. Looser monetary policy stimulates economic activity, making it easier for businesses, particularly smaller ones, to access capital and fuel expansion.

When interest rates are reduced, borrowing costs decline, providing small-cap companies with more favorable financing conditions. This can lead to increased capital expenditures, innovation, and overall business expansion. Moreover, lower interest rates make small-cap stocks more attractive to investors seeking higher returns, because the yield on alternative fixed-income investments tends to diminish.

As the Fed nears the end of its tightening cycle, the stock market as a whole has been rising. On Friday, the main U.S. stock market indices closed higher, as follows:

• DJIA: +0.01%
• S&P 500: +0.13%
• NASDAQ: +0.08%
• Russell 2000: +1.35%

Friday’s gains capped the third consecutive positive week for the four equity indices. The Russell 2000 was up 5% for the week. The 10-year U.S. Treasury yield ended the week at 4.44%, its lowest level since September. The CBOE Volatility Index (VIX), aka “fear index,” settled at 13.7, far below the bearish threshold of 20.

Read This Story: Investors Cheer as Inflation Loses its Punch

One of the key drivers of small-cap outperformance is the growth trajectory inherent in smaller, less mature companies. Small-cap stocks typically have more room for expansion compared to their larger counterparts, often because they operate in niche markets with the potential for exponential earnings growth. Investors who can identify and invest in these hidden gems at an early stage stand to benefit as these companies grow and gain market share.

Furthermore, small-cap stocks are less likely to be extensively covered by analysts and institutional investors, leading to potential inefficiencies in their pricing. This lack of widespread coverage provides astute investors with opportunities to uncover undervalued small-cap stocks before the broader market catches on.

The downsides of small-cap investing aren’t hard to guess. For one, these stocks are typically more volatile than their larger cousins. Small caps can also fall faster than large caps in a declining market. Another thing to keep in mind: dividends are rare in the small cap universe, as companies prefer to plow their profits back into the business in order to drive their growth.

The inherent volatility of small-cap stocks can be unnerving for investors with a low tolerance for risk. However, while small caps may experience more pronounced price swings in the short term, their volatility tends to smooth out over time, allowing patient long-term investors to benefit from the compounding effect of steady growth.

According to a study published in May 2023, over the 20-year period from 2000 to 2020, small-cap stocks (represented by the Russell 2000 index) delivered an average annual return of approximately 8.4%, while large-cap stocks (represented by the S&P 500 index) returned around 6.3%.

Small caps have struggled for most of 2023, largely due to inflation, rising interest rates and an unfavorable economic cycle. That means you can currently find compelling bargains before this asset class takes off next year.

Despite their recent ascent, U.S. small-cap stocks are trading at substantial discounts to large caps, creating attractive entry points. As you position your portfolio for 2024, make sure you have exposure to the little engines that can.

Looking for a specific small-cap stock that’s about surge? Turn to Dr. Joe Duarte, chief investment strategist of Profit Catalyst Alert.

Dr. Duarte has just pinpointed a tiny, unknown company that has developed a revolutionary “black box” technology. You need to get in on the ground floor of this game-changing opportunity before the investment herd finds out and sends the share price soaring. Click here for details.

John Persinos is the editorial director of Investing Daily.

To subscribe to John’s video channel, click this icon: