At the start of the year, the markets were too optimistic about the rate cut, and the market rallied only to fizzle out. Now, with renewed clarity on the rate cut, investors are ready to take on risk and buy the beaten-down stocks. It is also believed that smaller-cap stocks will benefit more from the rate cut as they are more affected by high interest rates than the big caps. Moreover, the Magnificent 7 have seen great returns so far this year, and some investors may have taken profits and rotated to other stocks that have yet to run.

The bigger question is whether the small-cap rally will sustain. I believe this time it should sustain for the next two months until September when the rate cut is expected. This is because we have never been so close and so certain—though not 100% certain, the confidence level is much higher than before—about a rate cut. This increased certainty should inject more confidence in investors.

However, when the rate cut does happen, it is often a curse, as stocks may start to correct. You can see the chart below where the beginning of rate cuts correlates with the fall in S&P 500 prices in the past three instances: the Dotcom crisis, the Great Financial Crisis, and Covid.

The Mag 7 was down 4.42% as a group, dragging the S&P 500 down by 0.86%. At the same time, the small-cap Russell 2000 was up 3.59%! There were 4,894 gainers and just 1,187 losers. So, the broad market rallied while the index was down.

Looking within the S&P 500 components heat map, we can see more greens than reds, but because the heavily weighted stocks were in the reds, they dragged the index down. The largest Mag 7 declines included Tesla (-8.44%), Nvidia (-5.57%), and Meta (-4.11%).

Thus, a mean reversion effect may happen now, especially as the disparity between the valuations of big caps and small caps is at its widest since 1999. 

Finally closing this gap should be seen as a healthy development for the market.