My twin grandsons, age seven, give me immeasurable joy. I especially enjoy reading bedtime stories to them. Recently 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. The iShares Russell 2000 ETF (IWM) is an ETF for profiting from them, advises John Persinos, editor of Investing Daily.

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 US companies, or roughly 98% of the investable US equity market. The Russell 2000 comprises about 10% of the larger index’s market cap.

After a prolonged slump, small caps jumped earlier in November, as evidenced by the upward momentum of the benchmark IWM. It broke above its 50-day moving average and it has been 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.

Recommended Action: Buy IWM.

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