Small-caps are breaking out and will rally 40% as the S&P 500 sputters, Fundstrat's Tom Lee says

• The Russell 2000 could rally 40% amid a shift in Fed policy, Fundstrat's Tom Lee told CNBC.
• The rotation out of large-caps will become evident in August, weighing on the S&P 500, he said.
• This rally should be bigger than the one seen last year, Lee added.

A rally may be brewing in overlooked parts of the stock market.

On Monday, the small-cap Rusell 2000 climbed 1.8%, reaching a high not seen in two and a half years. The index has notched gains amid signs of buckling in large-cap peers and a rotation out of the biggest winners of 2024 as markets position for rate cuts.

Last Thursday, the tech-heavy NASDAQ shed 2% as the Russell rose 3.6%.

"We have small caps even more oversold and valuations — whether you look at medium P/E, which is now at 10 times 2025 earnings — even lower," Fundstrat's Tom Lee told CNBC. "So we think that this move could be something like 10 weeks and as much as 40%. So I think it is just starting."

June's consumer price index report gave the Russell 2000 its green light to rally, he said, given how "astonishingly soft" the data was. That month, inflation cooled off more than expected, bolstering expectations that the Federal Reserve would cut interest rates come September.

Compared to names backing the S&P 500, stocks in the Russell 2000 tend to be more rate-sensitive. That makes higher interest rates a challenge for the index, but it rally when borrowing costs finally edge down.

"I think that August is really going to be one where the rotation becomes more evident, and I think it's going to be stronger small-caps and maybe flat, just slightly down for the S&P," Lee said.

In fact, when the Russell 2000 last rallied around 30% in the final months of last year, large-caps had similarly sputtered, Lee said. Given how oversold small-caps are today, the rotation could be even more sizable this time around, he added.

Currently, concern is looming over the makeup of major indexes, as just a handful of tech mega-caps are responsible for the majority of gains seen this year. The narrow market concentration looks similar to the previous bear market, Charles Schwab said recently.

But others are also noticing that small-caps are looking more attractive.

"This switch doesn't appear to be a 'one off' although it's far too early to suggest that we're experiencing a sustainable trend," Trade Nation's senior market analyst David Morrison wrote.

"Nevertheless, there's certainly a bullish interpretation to the rotation, as any profit-taking in 'overvalued' tech gets funneled into more neglected areas of the US stock market," he added.