The Rate Cut Playbook Is Activating
Before the Fed started cutting rates, the market had a clear preference: stick with the well-capitalized giants that could weather any environment. The Magnificent Seven dominated because they didn't need cheap money to thrive.
But that dynamic is shifting...
With rates heading lower and monetary conditions easing, capital is finally spreading out. Companies that were bludgeoned by high borrowing costs are suddenly getting a second look. The math is changing—and investors are repositioning accordingly.
Why falling rates disproportionately benefit small caps:
- Debt servicing costs drop immediately, expanding margins without any operational changes
- Access to capital improves, unlocking growth investments that were previously uneconomical
- Refinancing at lower rates allows balance sheet repair for overleveraged companies
- Risk appetite returns and money flows down the cap spectrum toward higher-beta names
This isn't speculation. It's the historical playbook. Small caps have consistently outperformed large caps in the 12 to 24 months following the start of a Fed cutting cycle.
We're in that window right now—and the early moves are already confirming the pattern!
The Valuation Gap Is Absurd
Years of mega-cap concentration have created a historic dislocation. The valuation gap between small caps and large caps hasn't been this wide in decades.
The MAG 7 sucked up so much capital over the past few years that everything else was left behind. That created pain for small cap investors—but it also created opportunity. The beaten-down names are now trading at levels that assume nothing goes right.
The perfect storm setup for small caps:
- Cheapest valuations relative to large caps in decades
- Earnings growth is converging with large caps for the first time in years
- Rate cuts are providing immediate relief to leveraged balance sheets
- Institutional neglect means the sector is under-researched and mispriced
When you combine historically cheap valuations with improving fundamentals and a supportive Fed, you get the conditions for a major catch-up trade. That's exactly what's starting to unfold.
AI Leverage Hits Different at Smaller Scale
Here's something most investors miss: AI-driven efficiency gains actually benefit small caps more than large caps.
The math is straightforward. A 200 basis point efficiency improvement translates to roughly a 33% EPS boost for a typical small cap company—versus just 11% for a large cap.
Why?
Operating leverage. Small caps run leaner, so margin improvements flow straight to the bottom line.
Why small caps amplify AI tailwinds:
- Higher operating leverage means efficiency gains translate to outsized earnings growth
- Less analyst coverage means AI-driven improvements aren't priced in yet
- Domestic focus aligns with reshoring trends and deregulation benefits
- M&A activity picks up in loose credit environments, making small caps acquisition targets
The reshoring narrative particularly favors small caps, which tend to be domestically focused. As supply chains continue shifting back to the US and deregulation accelerates under the current administration, these companies stand to benefit disproportionately.
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