The Russell 2000 (^RUT), which is made up of small-cap stocks, hasn't rallied the same way the big three indexes have (^DJI, ^IXIC, ^GSPC) this year. What could change the fortunes for small caps? Penn Capital Management CIO Eric Green says one thing that will help is getting a better idea of when the Federal Reserve will start to cut rates. He also points to credit spreads being at their cycle lows, saying "the credit market is suggesting we can get a really nice rally in small-cap equities."

Another potential catalyst is merger and acquisition activity. Green says that given valuations, "a large-cap company buying a small-cap company right now is very accretive." He goes on to say that he expects that we are at the beginning of an "M&A boom" that could lead to some small-cap companies being purchased by either a large-cap company or private equity.

For more expert insight and the latest market action, click here to watch this full episode of Yahoo Finance Live.

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Editor's note: This article was written by Stephanie Mikulich

Video Transcript

- The Russell 2000 up less than 1% so far this year. Our next guest, though, does see a turnaround ahead. Joining us now, Eric Green, Penn Capital Management CIO. Hi, Eric, good to see you. You have not been alone--

ERIC GREEN: Hi. How are you?

- --in your faith in small caps. That's been something we've heard from a lot of investors. And we did see a rally in the waning months of 2023 that then stalled out. What would reignite it?

ERIC GREEN: I think the market is going to start to broaden out. Earnings should be helpful. This will be the first year in the last three where small cap stocks will have better earnings growth than large cap stocks. But also just when there's more confidence that the Fed is going to start cutting rates, that should absolutely help small cap. Usually the credit market leads the equity market and credit spreads are near their lows or at their cycle lows right now.

So the credit market is suggesting we can get a really nice rally in the small cap and small cap equities.

- And so Eric, I think you just touched on a point. I want to double tap on there. How much of your thesis on small caps, Eric, is really dependent here on the Fed and their rate strategy?

ERIC GREEN: Yeah. Well, the Fed has already said that they're going to cut rates. So in the short run, the volatility in small caps, it'll be there based on whether the market thinks they're going to cut in May or in June or even further out than that. But at some point, the small cap stocks are going to reflect the fact that we are on the other side of the rate increases and rates are going to start to come down.