At the beginning of 2024, well-known Wall Street analyst Tom Lee made a bold prediction -- that the Russell 2000, which is the most widely used small-cap stock index, would rise by 50% in a year.
Spoiler alert: It didn't.
To be fair, the Russell 2000 produced an 11.5% total return in 2024, so it wasn't exactly a terrible year. But it underperformed the S&P 500, which returned 25% for the year, by a wide margin.
Lee's thesis was straightforward. At the beginning of 2024, small-cap stocks were trading at their lowest price-to-book (P/B) valuations relative to large caps in 25 years. And last time the gap was so large, small caps went on to outperform for more than a decade. But his thesis was predicated on something that didn't happen to the extent Lee expected -- falling interest rates. The Federal Reserve was widely expected to start cutting rates early in 2024 and continue to do so, but it waited until the end of the year and ended up pausing after just 75 basis points of rate cuts.
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Why this could be the year
I'm going to make the bold prediction that the Vanguard Russell 2000 ETF (VTWO 0.17%) could rise by as much as 50% over the next 12 months. (Note: I'm writing this on Aug. 8, 2025.)
Since Lee first made his call, not only have interest rates not moved as much as expected, but the valuation gap between small caps and large caps has widened even further. In all, since the beginning of 2024, the S&P 500 has outperformed the Russell 2000 by 24 percentage points. One eye-popping statistic is that the average stock in the S&P 500 trades for 4.9 times book value. Meanwhile, the average Russell 2000 component has a P/B ratio of just 1.8.
To be sure, I'm not saying the gap should narrow entirely. The S&P 500 is disproportionately weighted to asset-light tech giants and should command a somewhat higher price-to-book ratio. But that's a big gap and, as mentioned, by far the biggest disparity since the late 1990s tech boom.
It's looking like the Fed is finally set to start cutting rates in September. And when it starts, the cuts are likely to occur for a while. In fact, the median expectation, according to the CME FedWatch tool, is a total of five interest rate cuts over the next year.
Without turning this into an economics class, lower interest rates are disproportionately favorable for small caps, and for a few reasons. For one thing, small caps are generally more reliant on debt (as a percentage of market cap) than their large-cap counterparts, and lower rates mean lower borrowing costs. Small caps also tend to benefit from money coming off the sidelines and into the stock market when rates paid by certificates of deposit (CDs), savings accounts, and other risk-free instruments fall.
It isn't just the interest rate tailwinds. The generally lower-regulation focus of the Trump administration can make it easier for small caps to effectively compete, to name just one example.
Will the Vanguard Russell 2000 ETF rise by 50% in a year?
Of course, it would be an extraordinary move for any index fund to rise by 50% in a year. And there's a lot that would need to go right for the Vanguard Russell 2000 ETF to jump by that much. However, the bottom line is that over the long term, small-cap stocks should deliver excellent returns, and the valuation gap that exists right now could make it an excellent time for investors to take a closer look.
