Why the market's smallest stocks will surge 15% in August, according to Fundstrat's Tom Lee

Investors are keyed in on a September rate cut, and the flexibility that would afford debt-heavy small-caps.

• The small-cap-heavy Russell 2000 will jump 15% or more in August, Fundstrat's Tom Lee told CNBC.
• Investors are keyed in on a September rate cut, and the borrowing flexibility that would afford small-caps.
• Expectations of a Trump White house are also helping drive small-cap buying, Lee added.

With the tech sector tanking, smaller stocks are taking over the summer.

Fundstrat's Tom Lee told CNBC that the small-cap-focused Russell 2000 is likely to gain 15% or more through August, if history is any guide.

The index has already achieved steep gains throughout July, climbing more than 10% month-to-date through mid-day Thursday.

Lee says the market's certainty in upcoming interest-rate cuts — expected to commence in September — is helping drive the small-cap rally. Those firms have more debt exposure, and therefore poised to benefit most from lower borrowing costs. Conversely, persistently high interest rates have been cited as a reason for the Russell 2000's underperformance in recent years.

It's also worth noting that the small-cap index has seen a gradual rise, rather than a sharp, unsustainable increase, Lee said. He pointed out that the Russell 2000 has notched a 1% gain over the past 10 of 11 days.

"The nine times it did that since 1979, when you were in a bear market, we were up 100% — one month, three months, six months, 12 months later," he said. "The 12-month average gained 40%."

Lee previously projected the rally to last around 10 weeks starting in August, eventually notching 40%. He's now getting even more specific with his forecast, highlighting August as a particular standout period.

"For the month of August, small-caps can do something more than 15% even, because they underperformed so dramatically," he told the outlet. "The type of moves seen just in the last two weeks is something that only happens at the start of a pretty significant advance for small-caps."

Aside from easing interest rates, Lee also cited upcoming election outlooks for fueling the Russell 2000's rise.

With betting markets indicating a Donald Trump presidency, investors are likely enticed by small-caps. That's as Trump's policies would likely boost deregulation, M&A, and regional banks, Lee said.

Otherwise, Lee says the rally also signals that investors are moving on from large-cap trades, as the artificial-intelligence frenzy dims down. On Wednesday, the tech-heavy Nasdaq 100 hit its worst day since 2022, tanking 3.6%.

While the AI narrative remains intact over the long run, investors focused on free cash flow or price-to-earnings will find small-caps more attractive, Lee said.

Lee's optimism isn't universal. Despite the Russell 2000's surge, some on Wall Street are doubting the rally's durability, given small-caps' lackluster earnings, revenue, and profit margins.

Separately, Barclays has questioned the impact rate cuts have on the sector, citing that the small caps historically decline when monetary policy first starts easing.