Even smaller tech stocks are getting expensive. But these sectors could be your next big win.

Small-cap stocks look like they’ve finally roared back after the Federal Reserve resumed cutting interest rates following a nine-month pause — stoking hopes that cheaper borrowing costs could revive one of the most neglected corners of the stock market.

But a look under the hood shows the small-cap rally isn’t nearly as broad — or as healthy — as it appears.

Small-cap stocks, as represented by the Russell 2000 index RUT, have hovered near record territory this month, but the rally has left their valuations less attractive than before. By some measures, small caps now look almost as frothy as their large-cap counterparts, challenging the popular market view that years of underperformance have left them ripe for investors hunting for growth.

The iShares Russell 2000 ETF IWM on Friday traded at a forward price-to-earnings ratio of 24.64, compared with 22.32 for the iShares Russell 3000 ETF IWV and 22.50 for the large-cap SPDR S&P 500 ETF Trust SPY, according to Dow Jones Market Data.

The iShares Russell 2000 Growth ETF IWO on Friday traded at an even frothier level, with a forward P/E of 36.38, according to Dow Jones Market Data.

Adding to concerns is that the rally has been propelled by a small group of growth and technology stocks, rather than a wide range of small-cap companies.

A breakdown of the 11 sectors in the S&P Small Cap 600 index SML shows that tech-related sectors have dominated the gains, with the information-technology XX:SP600.45 and consumer-discretionary XX:SP600.25 sectors leading the charge — up 12.7% and 10.9%, respectively, so far this quarter — while the S&P Small Cap 600 has risen 8.3% in the same period, according to FactSet data.

Two other cyclicals sectors, industrials XX:SP600.20 and energy XX:SP600.10, have also posted double-digit gains since August — up 10.9% and 13.7%, respectively — though most other sectors have barely budged, according to FactSet.

To be sure, just as megacap technology stocks have dominated the gains in the large-cap market, small-cap growth names have also been the driving force within the small-cap universe. The Invesco S&P Small Cap Information Technology ETF PSCT has outperformed the S&P 600 small-cap index by an average of 1.25 points over any given 100-day holding period since it was launched in April 2010, according to Dow Jones Market Data.

“Tech stocks have had an incredible run, and it makes us nervous as it feels like an escalator ride on the way up and then an elevator on the way down, so we’re nervous about the technology sectors, both for small caps or large,” said Sandy Villere, portfolio manager at Villere & Co.

Small-cap stocks are typically more sensitive to changes in borrowing costs than their large-cap peers, as they tend to rely more heavily on external financing for their business operations. That’s why the Fed’s rate cut last week, as well as the possibility of more rate reductions later this year and in 2026, have buoyed this particular group of stocks.

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However, it’s far from a one-formula-fits-all story.

Some of the largest stocks in the Russell 2000 index have ballooned in value this year despite not generating a dime in sales.

For example, Oklo Inc. OKLO — one of the largest Russell 2000 constituents — has seen its shares soar nearly 100% so far this quarter. With an eye-popping $16.3 billion market capitalization, Oklo is one of the largest prerevenue companies listed in the U.S., as investors have piled into the nuclear-tech firm amid enthusiasm for its potential role in empowering AI data centers with small modular reactions.

According to FactSet, Wall Street doesn’t anticipate Oklo to bring in revenue until the fourth quarter of 2027. The company is expected to file its application for a license this year with the Nuclear Regulatory Commission to build its first 75-megawatt power plant, but they won’t launch commercial operations until late 2027 or early 2028.

Villere said his team “would rather play a bit more defense than offense” in small-cap stocks, as markets are still not sure how much further the Fed’s policy rate could fall from here. He recommends defensive sectors within the small-cap universe such as consumer staples, pharmaceuticals and healthcare.

“We’ve already got the first 25-basis-point cut and are probably going to get another one or two in 2025, but rates really have to come down much lower for cyclical sectors to work,” Villere told MarketWatch in a phone interview.

To be sure, many investors question the sustainability of the small-cap rally, fearing it could be just another head fake and may fizzle out soon.

Lori Calvasina, head of U.S. equity strategy at RBC Capital Markets, noted that one way to view it is by comparing the performance of small caps and home-builder stocks, as their performances relative to broader indexes have been aligned in recent years — at least until recently.

“Interestingly, home-building performance hit a high relative to the broader market in early September, then began to underperform. But the Russell 2000/S&P 500 ratio has continued to move up as small caps have continued to outperform,” a team of RBC analysts wrote in a client note earlier this week.

A separate RBC team focused on home builders has been “cautious” on the group, as they think “the stocks have run too far, too fast, valuations are stretched and interest-rate optimism has been overdone.” The analysts also noted that home affordability remains extremely stretched and that the long end of the curve is not coming down enough to alleviate that problem.

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Bob Savage, head of markets macro strategy at Bank of New York Mellon, said that since the Russell 2000 is more heavily weighted in rate-sensitive areas, it makes him concerned that “we are not out of the woods yet.”

Savage told MarketWatch that markets are likely to stay in “wait-and-see mode” ahead of next week’s potential government shutdown and the September jobs report, as well as the start of the third-quarter earnings season in mid-October.

U.S. stocks booked weekly losses on Friday, with the S&P 500 SPX down 0.3% for the week, while the Dow Jones Industrial Average DJIA fell nearly 0.2% and the Nasdaq Composite COMP dropped nearly 0.7%. The small-cap Russell 2000 was off 0.6% for the week, according to FactSet data.