One of investors' biggest fears about the stock market is fading

• The S&P 500 rally is broadening beyond mega-cap tech stocks to smaller companies.
• That's a great sign for the sustainability of the current bull market.

One of the prevailing sources of fear about the strength of the stock market rally in 2024 is dissipating.

The stellar run of gains that's helped the S&P 500 notch more than 30 record highs so far this year is finally broadening out. In other words, it's not just a handful of mega-cap tech stocks that are driving the S&P 500 and Nasdaq 100 higher anymore.

That's a big win for the bulls, as one of the bigger concerns of the ongoing rally that started in October 2022 was a lack of breadth, or participation, from smaller-sized companies, which goes hand-in-hand with the historic concentration in the so-called "Magnificent 7," — Apple, Amazon, Alphabet, Microsoft, Nvidia, Tesla, and Meta Platforms.

And the rally in smaller-cap stocks, which exploded last week on the prospect of imminent interest rate cuts following the cooler-than-expect June CPI report, is reaching historic levels.

According to Bespoke Investment Group, the small-cap Russell 2000 Index is on track to notch a five-day win streak of more than 10% after it gained an additional 2.5% on Tuesday.

"If today's rally holds, this will be the Russell's 5th straight trading day of 1%+ gains. There have only been four other five-day streaks of 1%+ gains in the index's history dating back to 1979," Bespoke said in an email on Tuesday.

Perhaps what's more impressive than the massive rally in small-cap stocks is that large-cap stocks have largely missed out on the gains over the past week.

"If today's move holds through the close, this will be the biggest five-day outperformance that the Russell 2000 has ever seen against the S&P 500!" Bespoke said, with the relative outperformance nearing nine percentage points.

And according to UBS, the rotation into smaller-cap stocks, which is considered healthy for the broader market, could have legs if four things happen.

The bank said in a note on Tuesday that as long as inflation remains contained, the Fed starts cutting interest rates, the economy continues to grow, and earnings growth extends to smaller companies, the broadening out of the stock market rally should continue.

In other words, a lot has to go right for this small-cap trade to work, which leaves UBS somewhat cautious on its recent rally.

"While all of these four factors seem very much possible and, on the table, it might take a disappointment in only one area to send any signs of broadening into reverse," UBS said, adding that the first two conditions seem more likely than the last two.

But Shannon Saccocia, CIO of Neuberger Berman Private Wealth, expects small-cap earnings to see big improvements going forward.

"This broadening out is consistent with our view that earnings outside of the largest U.S. stocks have opportunities to deliver earnings growth in the second half of the year, while the top names are likely to experience an incremental deceleration in earnings growth – although admittedly still at attractive absolute and relative levels," Saccocia told Business Insider via e-mail on Tuesday.

Carson Group chief market strategist Ryan Detrick also sees a sustainable rally in small-cap stocks going forward.

"We've expected this bull to broaden out and now that inflation is last year's problem and interest rate cuts are on the way, it has provided cover for investors to move into the more rate sensitive smaller names. In the second half of this year, we expect to see things like small/midcaps and industrials and financials to take the baton from large cap tech, which would be perfectly normal at this stage of the bull market," Detrick told Business Insider in an e-mail on Tuesday.

And such an event would ultimately dispel the bearish concern among some investors: that the stock market rally is too narrow.

"In a healthy bull market, you want to see wider participation," Detrick said. "Never forget, the lifeblood of a bull market is rotation and we see that happening the remainder of this year."