Small-cap stocks, as indicated by the Russell 2000 Index, have lagged their bigger peers so far this year.Small-cap exchange-traded fund (ETF) iShares Russell 2000 (IWM Quick QuoteIWM - Free Report) is up 4.4% this year versus gains of 21% in the S&P 500, 21.6% in the Nasdaq-100 ETF (QQQ Quick QuoteQQQ - Free Report) and 11.8% in the Dow Jones.

And why not? Higher borrowing costs weighed on the small caps’ capital expenditure. After such lackluster performance, can small caps turn around? Let’s delve a little deeper.

U.S. Economy Grows Faster Than Expected in Q2

The U.S. economy grew at an annualized rate of 3% in the second quarter of the year, surpassing Wall Street's expectations. According to the Bureau of Economic Analysis's third estimate, this growth rate remained unchanged from the previous estimate. Economists had estimated the reading to show an annualized growth of 2.9%. The second-quarter growth marks a significant improvement from the 1.4% annualized growth seen in the first quarter.

Strong Economic Outlook

Michael Pearce, deputy chief economist at Oxford Economics, commented that the revised GDP figures shows confidence in continued economic expansion.

Pearce noted that this sustained growth suggests that labor market conditions are unlikely to deteriorate significantly in the near future, as quoted on Yahoo Finance.

Since small-cap stocks are more domestically-focused, an improving U.S. economy should bode well for the pint-sized stocks. Also, early indicators suggest continued growth of the U.S. economy in the third quarter.

The Atlanta Fed’s GDPNow tracker forecasts an annualized growth rate of 2.9% for the third quarter, while Goldman Sachs projects a matching rate of 3%, as quoted on Yahoo Finance.

Unemployment Claims Decline

In a separate report, the U.S. Labor Department revealed that 218,000 unemployment claims were filed for the week ending Sept. 21. This figure came in below Wall Street’s expectation of 223,000 and marked the lowest number of weekly claims since mid-May.

Federal Reserve’s Interest Rate Cut

These economic updates come on the heels of a Federal Reserve decision to cut interest rates by half a percentage point. Fed Chair Jerome Powell, after the Sept. 18 decision, stated that the economy is "growing at a solid pace," while inflation is cooling and the labor market remains decent. The start of the monetary easing cycle is a great plus for small-cap stocks and ETFs.

What Does Small-Cap Stock Valuation Say?

Per WSJ data, the Russell 2000 is currently trading at a P/E ratio of 25.12, versus the year-ago level of 25.64. The Russell 2000 is trading at a discount to the Nasdaq 100. The Nasdaq 100 Index is trading at a P/E ratio of 30.92X, above the year-ago level of 29.75X, per Wall Street Journal. In comparison, the S&P 500 Index is currently trading at a P/E ratio of 23.98, up from the year-ago level of 21.67. It shows that small caps are neither cheap nor overvalued.

Small-Cap ETFs in Focus

Here are a few small-cap U.S. ETFs that have topped the list in their segment. Investors can keep a close track of these ETFs.

iShares MSCI USA Small-Cap Min Vol Factor ETF (SMMV Quick QuoteSMMV - Free Report) – Up 1.3% past month

ALPS O'Shares U.S. Small-Cap Quality Dividend ETF (OUSM Quick QuoteOUSM - Free Report) – Up 0.8% past month

Vanguard Small-Cap ETF (VB Quick QuoteVB - Free Report) – Up 0.7% past month

Invesco S&P SmallCap Quality ETF (XSHQ Quick QuoteXSHQ - Free Report) – Up 0.5% past month