Back in May, I made what felt like a somewhat contrarian argument.
I suggested that the Federal Reserve was preparing to shift from an easing bias to a tightening bias, and that the market might actually welcome a rate hike rather than fear it. The reasoning was simple: a Fed that stays ahead of inflation is usually less damaging than one that falls behind it.
Last week, we got our answer.
The Fed raised rates by 25 basis points and signaled that another hike remains on the table before year-end. Normally, that kind of news would be expected to pressure stocks, particularly smaller companies, which tend to be more sensitive to borrowing costs.
Instead, the market’s reaction suggests investors may be looking at the bigger picture.
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Consider what has happened since the Fed’s September 16 decision through Monday’s close.
The 10-year Treasury yield has slipped from roughly 5.0% to 4.96%. Oil prices have fallen sharply, from around $102 per barrel to roughly $90. Meanwhile, the S&P 500 has gained 2.8%, the Nasdaq has rallied 5.2%, and the iShares Semiconductor ETF (SOXX) has surged 11.4%.
Those aren’t the types of price moves you’d expect if investors thought the Fed had just made a serious policy mistake.
Rather, the market appears to be growing more comfortable with the idea that inflation can be contained without derailing economic growth.
That’s important because the jump in crude oil above $100 and the surge in the 10-year Treasury yield toward 5% were creating legitimate concerns that inflation expectations could become unanchored. Had that happened, the Fed may ultimately have needed to take even more aggressive action later.
Viewed through that lens, one or two modest rate hikes may be preferable to allowing inflation, oil prices and yields to continue climbing unchecked.
That appears to be the message investors are sending today.
What about small caps? They have not been the market’s leaders over the last few trading sessions.
Since the Fed meeting, through Monday’s close, the S&P 600 SmallCap Index has slipped 0.2%, while large caps and technology stocks have posted solid gains. Some of that underperformance is understandable. Small caps were hit particularly hard as the 10-year yield climbed from roughly 4.6% in August to 5.0% earlier this month.
As I wrote in last week’s Cabot Small-Cap Confidential update, small companies tend to rely more heavily on floating-rate debt and generally have fewer financing options than their larger peers.
But stepping back, the bigger picture for small caps remains very compelling.
Why Small Caps Can Continue to Thrive
Even after the recent pullback, the S&P 600 is still up 15.9% year to date, ahead of the S&P 500’s 13.4% gain. The performance gap has narrowed, but small caps are still leading in 2026.
Looking ahead to 2027, analysts expect earnings in the S&P 600 to grow by 15.9%, compared to 15.2% for the S&P 500. Yet small caps continue to trade at a meaningful valuation discount. The S&P 600 currently carries a forward P/E ratio of 14.4, versus 19.2 for the S&P 500.
In other words, investors can still buy slightly faster projected earnings growth with small caps, and at a substantially lower valuation.
That’s a compelling combination.
I don’t think small caps – or the broad market for that matter – are going to surge higher immediately, however. It’s worth remembering that we’re still in September, historically one of the weakest months of the year for stocks.
The next major catalyst will likely be third-quarter earnings season, which begins in earnest in mid-October. If corporate results continue to support the resilient economic backdrop that Fed Chair Kevin Warsh discussed after last week’s meeting, investors may become even more comfortable with the idea that “higher for longer” might not mean slower growth.
That’s really the key takeaway from the market’s reaction to the latest rate hike.
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