A lot of what I wrote last month in this letter continued to apply throughout the entirety of August and into the first three weeks of September. The U.S. equity market finished August up about two percentage points, led by strong performance from small-cap stocks, broad indexes for which rose about 7%. Strong relative performance for the small fry has continued as of this writing, on September 19. Case in point: iShares Core S&P Small-Cap (IJR), with a modest tilt toward value, still has a disappointing year-to-date return but gained nearly three percentage since the beginning of the month; Vanguard Extended Market (VXF), a leading index ETF for small- and mid-cap stocks, with a slight growth bias, has tacked on nearly four percentage points of gains and was recently up double digits for the year so far. (We own these ETFs in various accounts.)

Smaller stocks produced especially strong returns on September 18, the day after the Federal Reserve Board trimmed the federal funds rate by 25 basis points, to a range of 4.0% to 4.25%, citing a weaker employment picture.

Conventional wisdom has it that small stocks rally when the Fed cuts rates. I generally agree, albeit with the caveat that if the Fed is cutting because of a recession, the negative impacts of the latter may outweigh the positive impacts of the former. Because smaller value-oriented companies tend to borrow at shorter-term, often floating, rates, cuts in such rates flow quickly to their bottom lines. With smaller growth companies, lower short-term rates, especially if longer-term rates fall in concert, increase the value of their potential future cash flows in today’s dollars, creating buying pressure that can boost their stock prices.

In a recession, however, small stocks tend to struggle mightily until investors see the light at the end of the economic tunnel, regardless of how much the Fed cuts the rates under its control, for two main reasons: One, investors tend to respond to recessions by moving from higher-risk assets like small stocks to lower-risk ones like large stocks and high-quality bonds; and two, small companies simply have less financial wherewithal to withstand significant drops in demand for their products and services than do large companies with ample financial reserves and easier, lower-cost access to capital.

On the question of whether we are in or will soon enter a recession, the weight of the data says no. For example, while new job creation has stalled, layoffs are low as well. This means consumer spending is likely to hold up. Meanwhile, while tariffs likely dampen economic activity, at least in the short run, aspects of the so-called Big Beautiful Bill (signed into law by President Trump in July) will likely inoculate the economy at the corporate level and, eventually, the consumer level as well.

In fact, with lower short-term rates and more impact from fiscal stimulus from Washington, the economy is likely to be growing faster next year than it is now. Therefore, the recent good times for smaller stocks have a good chance of continuing, at least for a while (though nothing’s a certainty in this business).

Another question is whether the Fed’s cut in rates is a one-time thing or the first of several the rest of this year and in 2026. While most Wall Streeters seem to think as many as four or five more cuts are in the offing over the next 15 months, the dot plot representing the projections of an appropriate federal funds rate for the end of 2025 (and beyond) by the Fed’s own members is far from unanimous. Though a majority at the Fed expects that another cut or two in the federal funds rate would be appropriate by year-end, a sizable minority think the current rate is just fine for now. Meanwhile, the central Fed tendency of expectations for 2026 is for fewer rate cuts than Wall Street currently expects.

However, if the economy picks up but inflation behaves such that the Fed believes it can cut rates several more times, corporate profits would likely be strong and the stock market could continue to perform, including smaller stocks. The proverbial skunk at the garden party would be valuations, which are high not only at the top of the S&P 500 but also for the entire index, even when market capitalization is removed from the picture. However, as we’ve said many times previously, while the market’s valuations have some utility in projecting longer-term returns, they’ve not been helpful in recent years (even decades, really) in helping to project short-term ones. In other words, while valuations are a reason to be vigilant, they aren’t a good reason to be bearish.

Therefore, while I see the high valuations as suggestive of significant risk of big drops if things go wrong, I am dealing with that by diversifying assets across many corners of the market, generally favoring lower-valuation equities that I believe should hold up better during market turmoil.