(Bloomberg) -- The rapid cooling in US inflation is pushing the Russell 2000 Index to its best performance since Nov. 10, 2022, as beaten down small caps rally with traders erasing bets on more Fed hikes. 

The Russell 2000 was up roughly 4.5% midway through Tuesday’s session, more than doubling the 2% gain in the broader S&P 500 Index. That’s a reversal of recent trends, considering that through Monday the small-cap benchmark was down 15% since its July 31 high, compared with a 3.9% decline in the S&P 500.

“We are in the darkest hour before the dawn,” said Amy Zhang who runs Fred Alger Management’s Small Cap fund. 

The encouraging consumer price index report is sparking moves in assets across markets, with the yield on 10-year Treasuries falling to the lowest since September and the dollar tumbling as well. A peak in interest rates and a wide valuation gap between the Russell 2000 and S&P 500 historically presents the best time to invest in small caps, Zhang said. 

The massive underperformance of small-cap stocks this year was driven by concerns of an economic downturn, inflation and the impact of continued Fed hikes. That combination tends to weigh on those companies, which are more sensitive to economic growth.  

With the Russell 2000’s forward price-to-earnings ratio falling to a 14-month low, BofA analysts led by Jill Carey Hall noted that for long-term investors, it implies a 12% annualized price returns over the next decade versus 7% for the large cap Russell 1000 Index.  

Small caps remain historically cheap, trading at a 19% discount from their typical valuations. By comparison, mega-cap shares have an 18% premium and large caps have a 12% premium, according to BofA.

Of course, index construction also matters in assessing the strength of US small- and mid-cap stocks. 

“S&P indices will have a higher quality element while Russell benchmarks (particularly for small cap) face a negative earner issue,” Scott Chronert, US equity strategist at Citigroup wrote in a note. The Russell 2000 has a large component of mostly unprofitable biotech firms, whereas the S&P has little of that exposure. 

While the earnings expectations for small- and mid-cap companies earnings aren’t as robust as they are for big caps, Chronert thinks they may be an interesting substitute for a “value” allocation in a portfolio. He suggests looking at the S&P 1000 Index, which combines small and mid caps and has a relatively high correlation to S&P 500 equal weight and enhanced value indexes — is delivering stronger earnings.  

That said, some investors are questioning how sustainable this small-cap rally can be, considering that over 30% of stocks in the Russell 2000 are unprofitable. 

“If rates are dropping because we are entering a recession, we could see small cap underperformance resume,” said Cameron Dawson, chief investment officer of Newedge Wealth. 

©2023 Bloomberg L.P.