As I pointed out in a previous column, the Street has become significantly less fearful of small-cap stocks and medium-cap stocks than in 2022 and the first 10 months of 2023. Still, those equities continue to meaningfully outperform their large-cap peers. Over the longer term, however, the bears driving the small-cap and mid-cap names down through short selling will likely give up their efforts, enabling many of those stocks to undergo huge short-covering rallies. Additionally, rate cuts by the Federal Reserve will eventually spur many more large investors to buy the shares of relatively small firms.

The Extent of the Underperformance

The S&P 500, which has become increasingly dominated by large-cap tech stocks, has climbed 11.6% in the last three months and 28% in the past year. The index also advanced 4% over the last month.

Conversely, the Russell 2000, made up of small-cap stocks and mid-cap stocks, rose 2% in the last month, while the index rose only 6% over the past 12 months. The index rose 12% over the last three months, nearly matching the S&P 500’s performance. Still, it’s clear that the Russell has, on the whole, tremendously underperformed the S&P 500, showing large-cap stocks greatly outperformed their mid-cap and small-cap peers.

The Real Reasons for the Underperformance

Many pundits and traders have said that the Russell 2000 underperformed because of the inferior fundamentals of small-cap names and because higher interest rates are hurting smaller firms more than larger ones.

There’s some truth to the assertion since a much higher percentage of small firms than large ones tend to be unprofitable. Consequently, small companies usually need to borrow more money than larger ones, leaving small businesses more vulnerable to elevated rates.

On the other hand, a large proportion of small and medium companies are benefiting a great deal from the strength of the U.S. economic expansion. Some are also benefiting from huge, positive trends, such as the AI boom, the electrification of transportation and high infrastructure spending by Washington.

Also importantly, a huge percentage of small-cap and mid-cap names got crushed in 2022 and the first 10 months of 2023, so the impact of higher rates was more than reflected in their stocks. Yet small caps and medium caps have continued to underperform this year.

Given these points, I don’t think any real gap in the fundamental value of large firms versus their small and medium peers is causing the performance gap. Any challenges small and medium firms faced due to higher rates were already reflected in their valuations by the end of 2022.

In my view, what’s happening is that investors mistakenly convinced that higher rates would sink the entire economy and cause the stock market to struggle for a few years have been forced to concede they were wrong. But they are still sure higher rates will crush the vast majority of small stocks and mid-cap names. And they are 100% positive it will destroy any currently unprofitable firms. As a result, many investors are shorting small-cap and mid-cap names in general and unprofitable names within those categories in particular.

Many Short-Selling Rallies Are Coming

There are a few reasons why most of the bears selling small-cap stocks and medium-cap stocks short will ultimately be proven wrong.

First, as I’ve pointed out in past columns, “I agree with former Federal Deposit Insurance Chair Sheila Bair who wrote on October 2nd that ‘Truly promising innovations will attract capital. They always do.'” In other words, despite high-interest rates, small companies with great products and huge potential will attract funding, enabling them to survive and eventually thrive.

Secondly, many small and medium companies are working hard to become profitable. For example, among the companies whose shares I own, Rivian (NASDAQ:RIVN) expects to start generating positive gross profits by the end of this year while BlackBerry (NYSE:BB) plans to be “operating cash flow positive” by the end of its fiscal year starting March 1. As these firms move closer to profitability, they will be much less reliant on loans, greatly reducing their vulnerability to interest rates.

Further, John Templeton, known as a legendary Wall Street fund manager, famously said, “Bull markets are born on pessimism, grow on skepticism, mature on optimism and die of euphoria.” Multibillionaire investor Ken Fisher, who often quotes this line, believes that we are in the early phases of optimism. Therefore, I believe as the Street becomes more bullish and less afraid of high interest rates, small-cap and mid-cap stocks will rally.

Finally, the Fed has indicated it still plans to cut interest rates. As I noted previously, many small-cap and mid-cap names have strong positive catalysts and favorable valuations.

On the date of publication, Larry Ramer held long positions in RIVN and BB. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.