One of Wall Street's favorite calls to start 2024 has finally been leading the stock market rally.
After significantly underperforming the broader market for the first six months of the year, small caps have soared over the past week. The historic rally followed a better-than-expected June inflation reading that has markets increasingly optimistic about Federal Reserve interest rate cuts.
In the past month, the small-cap Russell 2000 (^RUT) index has gained about 8%, far outpacing the S&P 500's less than 1% in the same period. On Thursday, however, the move showed some signs of stalling out. The Russell 2000 dropped more than 2%, extending losses from Wednesday's trading session.
And the pressing question among Wall Street strategists right now is whether the rally has more room to run.
"We think there is room for the rotation into low quality to persist if rate cuts remain priced and the Trump 2.0 trade carries on ahead of US elections," UBS Investment Bank US equity derivatives strategist Maxwell Grinacoff wrote in a note to clients on Thursday.
Grinacoff added that the keys to the rally continuing include further cooling in inflation and economic data showing similar, or higher, levels of growth.
From the day of the latest inflation print on July 11 through July 16, the rally in small caps was historic.
As investors moved to price in a 100% chance of an interest rate cut from the Fed in September, the Russell 2000 rose than 11% in five trading days, including a more than 3% bounce on Tuesday alone. This marked the largest outperformance from the S&P 500 in five-day period on record, per Bespoke Investment Group.
DataTrek co-founder Nicholas Colas noted this historic action signals "investor sentiment has shifted dramatically and the move very likely has further to run."
On Wednesday, Bank of America's head of US equity and quantitative strategy Savita Subramanian told Yahoo Finance the trend in small caps is "likely to persist."
But to Subramanian that doesn't mean simply buying the Russell 2000 index is the right trade.
Subramanian highlighted about one-third of the Russell 2000 isn't profitable, and overall the index faces far more refinancing risks amid higher interest rates than an index like the S&P 500.
"Their valuations are at levels that would warrant a pretty equitable comeback," Subramanian said.
Still, Subramanian isn't overly confident in the index as a whole, noting that areas that have more refinancing risk or credit sensitivity are "potentially still in the penalty box until the Fed actually begins to cut rates."
Josh Schafer is a reporter for Yahoo Finance. Follow him on X @_joshschafer.
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