The US economy expanded at a faster-than-expected pace in the second quarter of 2024. The Bureau of Economic Analysis's advance estimate of second quarter US gross domestic product (GDP) revealed that the economy grew at an annualized pace of 2.8% in Q2, well above the 2% growth expected by economists surveyed by Bloomberg, as quoted on Yahoo Finance. The reading came in higher than first quarter GDP, which was revised down to 1.4%.

While this is fact to be cheerful about, little downbeat data points are probably waiting ahead. Nationwide financial markets economist Oren Klachkin said that “we should receive cooler GDP reports from here on out as consumers tighten their purse strings and businesses become more reticent to invest and hire,” as quoted on Yahoo Finance.

Meanwhile, the "core" Personal Consumption Expenditures index, which eliminates the volatile food and energy categories, increased 2.9% in the second quarter, above estimates of 2.7% but significantly lower than the 3.7% gain in the prior quarter. There is a 100% chance that the Fed would cut rates by the end of its September meeting.

Time for Small-Cap ETFs?

Small-cap stocks generally lead the way higher on improving American economy as these are closely tied to the domestic economy and generate most of their revenues from the domestic market. In any case, investing rotation is happening from technology (due to apparent “AI fatigue”) to small-caps. Small-cap stocks have outperformed the Nasdaq-100 by approximately 18% over the last 11 sessions.

Investors should note that small-cap ETFs like Invesco KBW Regional Banking ETF (KBWR Quick QuoteKBWR - Free Report) (up 21.9% past month), iShares US Small Cap Value Factor ETF (SVAL Quick QuoteSVAL - Free Report) (up 14.65% past month), ALPS Medical Breakthroughs ETF (SBIO Quick QuoteSBIO - Free Report) (up 12%), WisdomTree U.S. SmallCap Fund (EES Quick QuoteEES - Free Report) (up 10.7%), Avantis U.S Small Cap Equity ETF (AVSC Quick QuoteAVSC - Free Report) (up 10.4%) and JPMorgan Active Small Cap Value ETF (JPSV Quick QuoteJPSV - Free Report) (up 9.6%) have gained handsomely in the past one month.

Investors should also note that small-cap stocks are better plays if political issues or economic turmoil creep into the picture as the pint-sized stocks generate most of their revenues from the domestic market. Escalating tensions in the Middle East and the ongoing Russia-Ukraine war drive the appeal for small-cap stocks as these are exposed to global tensions.

Projected Q4 Performance: S&P 600 Versus 500

Per Zacks Earnings Trends issued on Jul 24, 2024, the S&P 500 earnings are projected to increase 9.6% in Q2 on 4.9% higher revenues. This increment in earnings will follow a 7.1% increase in Q1. Revenue growth in Q2 was 4.4%.

Looking at Q2 as a whole for the small-cap index S&P 600, total earnings are expected to be down 7.9% from the same period last year on 2.1% higher revenues. This will follow 27.7% earnings decline in Q1. Revenue growth in Q1 was 1.2%. This shows that the earnings picture of the small-cap segment is improving slowly.

The upcoming Fed rate cuts would be extremely beneficial for small-cap stocks as these pint-sized companies suffered a lot during the high-rate era. Inflation is also cooling, another winning factor small-caps.

What Does Small-cap Stocks Valuation Say?

Small-cap stocks seem cheap compared to their expensive large-cap counterparts. Per WSJ data, the Russell 2000 is currently trading at a P/E ratio of 28.75, slightly above the year-ago level of 26.96. In comparison, the S&P 500 Index is currently trading at a P/E ratio of 24.21, up from the year-ago level of 20.37.

But then, the Russell 2000 is trading at a discount to the Nasdaq 100. The Nasdaq 100 Index is trading at a P/E ratio of 31.89X, above the year-ago level of 32.72X, per Wall Street Journal. It shows that small caps are neither massively cheap nor overvalued.