It's not quite a Santa Claus rally, but it's starting to feel like one. Since the S&P 500 jumped 9% in November, the benchmark index has tacked on another 3.3% through Dec. 14, soaring after the Federal Reserve indicated it was likely done raising interest rates.
The Fed even forecast three interest rate cuts in 2024 as it gets closer to achieving the "soft landing" it's been aiming for, meaning bringing down inflation without causing a recession.
One of the easiest moves investors can make is to buy a broad index fund, such as the SPDR S&P 500 ETF (SPY -1.05%) or the Vanguard 500 Index Fund (VOO -1.04%). Both offer low-cost ways to get exposure to the 500 large-cap U.S. stocks that make up the S&P 500.
However, as we get ready to turn the calendar to a new year, there's a better index fund one can own today.
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A small-cap recovery is afoot
Large-cap stocks dominated 2023 as the "Magnificent Seven" were all big winners this year. However, new bull markets, which we're on the verge of now, typically broaden as they mature, and that seems to be what's happening now.
As investors prepare for interest rates to come down next year and grow confident that the economy will avoid a recession, small-caps stocks are starting to beat large caps. Take a look at the chart below.
As you can see, the Russell 2000 small-cap index has outperformed the S&P 500 by a significant margin. The Russell 2000 comprises small-cap stocks, so it tends to be more volatile than the S&P 500. However, that works toward investors' advantage during times like these.
You might notice that the Russell 2000 has soared on three particular occasions on that chart. The first came on Nov. 14 when the October inflation report came in cooler than expected, persuading investors that the Fed was unlikely to raise interest rates again. The Russell gained 5.4% during that session as small caps are considered more sensitive to interest rates than the titans that make up the S&P 500.
Smaller companies have less access to capital, often have weaker balance sheets, and are more likely to feel the impact of a recession, which could mean bankruptcy for some small caps. Lower interest rates, therefore, act as more of a lifeline for the sector, especially since many small caps aren't even profitable.
By contrast, S&P 500 companies must be profitable on a generally accepted accounting principles (GAAP) basis to gain admission to the index. Small caps surged again on Dec. 1 when Fed Chair Jerome Powell gave dovish remarks at a conference and again after the Fed's recent decision to hold rates steady and its forecast to cut them next year. All three times, the Russell 2000 easily beat the S&P 500.
The small-cap index also has a history of outperforming the S&P 500 during early-stage bull markets, and that could be especially true this time as it's still 20% below its peak, compared to the S&P 500, which is near its all-time high. As you can see, small caps still have a lot of ground to gain against their larger peers.
1 index fund to take advantage in 2024
The best way for investors to capitalize on the likely rebound in small-cap stocks is to buy shares of the iShares Russell 2000 ETF (IWM -1.46%), the largest index fund that tracks the Russell 2000. It's a popular investment, with $54 billion in net assets, and its expense ratio is relatively small at 0.19%.
Nobody knows what next year will bring investors, but small-cap stocks will likely outperform as interest rates come down. History has also shown that small caps tend to outperform in early bull markets. If you expect the stock market rebound to continue into 2024, buying the iShares Russell 2000 ETF should look like a smart move this time next year.
