Following a better-than-expected consumer price inflation report this week, Treasury yields fell dramatically and equities surged. The rally was most pronounced for the shares of smaller U.S. companies. The Russell 2000, an index that captures the stock performance of 2,000 small companies, known as "small caps," had its best performance in a year, rising by 5.44% . There is a very good chance that Tuesday’s pronounced rally is just the beginning of a multiyear rally in smaller domestic companies.

Small caps have dramatically underperformed larger companies whose share prices are tracked by the S&P 500. For the year, the S&P 500 is up almost 18%, but small caps are only up about 2% as measured by the Russell 2000 index. Over time, small caps tend to outperform large capitalization companies. That's because they often grow faster than larger companies. Large U.S. companies tend to grow revenues in line with nominal gross domestic product. New companies, however, are the most dynamic part of the U.S. economy. New companies start small and tend to rely on capital markets in order to finance growth. When capital markets free up, smaller companies can more easily access the necessary financing to grow. And mergers and acquisitions among small caps are more frequent.

Until the equity markets surged on Tuesday, the relative underperformance by small caps was the largest in a decade. I anticipate that small caps will outperform as they close the valuation gap with large companies. Small caps are trading at about 11 times forward earnings. The stocks which make up the S&P 500 are trading at about 18 times forward earnings. I believe that it is reasonable to assume that the stocks that make up the Russell 2000 can trade at 15 times 2024 earnings in an environment when the Federal Reserve is no longer raising interest rates.

Lower interest rates and the probability of rising earnings are the recipe for a powerful rally by small caps. The Russell 2000 index appears to be an attractive investment opportunity not only because of its recent dramatic underperformance but also because of the large number of regional banks that make up the index. Regional banks have an 18% weighting in the Index. By investing in the Russell 2000, an investor can capture what should be a powerful rally in regional banks, which are selling at their lowest valuations in decades. Many regional banks are selling below book value and with price earnings multiples in the mid-single digits.

In addition, the market suggests that the Fed is finished raising rates and in fact will probably be cutting interest rates around the middle of 2024, less than eight months away. Rate cuts will dramatically reduce the pressure on net interest margins of smaller banks. Their costs to fund deposits will fall. Wider net interest margins are good for the share prices of the smaller banks and in turn the performance of the Russell 2000.

Top line: This week, the inflation picture changed. There is a probability that the Fed has won the inflation fight. In less than a year, the Fed should be cutting rates. Equity markets are forward looking. My wager is that investors will now look to small caps, including smaller regional banks, for the most leveraged way to make money by investing in equities .

James Rogan is a former U.S. foreign service officer who later worked in finance and law for 30 years. He writes  a daily note  on finance and the economy, politics, sociology, and criminal justice.