Forgotten, overshadowed and eager for attention - small caps spent the past four years struggling in the darkest corners of the stock market.

Now, they are finally vaulting back into the spotlight, leading Wall Street's latest charge higher and ending a drought that dates all the way back to the pandemic.

Small-cap stocks, as represented by the Russell 2000 index RUT, on Thursday surged over 2.5% to finish at 2,467.70 - outperforming the three large-cap benchmark indexes a day after the Federal Reserve decided to lower interest rates for the first time in nine months.

The rally also propelled the small-cap benchmark to its first record closing high since November 2021, ending a streak of 967 consecutive trading days without a new record close, according to Dow Jones Market Data.

U.S. stocks surged across the board on Thursday as investors cheered the Fed's decision to cut its policy rate by 25 basis points, to a range of 4% to 4.25%, while penciling in two more rate reductions at its remaining meetings this year. However, it was small caps that were really taking off on Thursday, extending their quarter-to-date rally ever since markets priced in the resumption of the Fed's rate-cutting cycle.

The Russell 2000 has popped nearly 13.5% since August, compared with a 6.9% advance for the large-cap S&P 500 SPX and a 10.3% rise for the tech-heavy Nasdaq Composite COMP over the same period, according to FactSet data.

Michael Reynolds, vice president of investment strategy at Glenmede, cited the Fed's rate cut, potential small-cap earnings growth and the valuation gap with large-cap companies as key tailwinds behind the Russell 2000's recent rally - and drivers that could sustain further upside in small caps.

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. They're also more vulnerable to shifts in economic conditions, yet that vulnerability presents a paradox to small caps and other cyclical sectors of the stock market: The same economic weakness that could prompt the Fed to continue cutting rates might also weigh on these rate-sensitive stocks.

For example, weak economic data - such as higher unemployment or lower payroll growth - support stocks only to the extent that they reinforce expectations for further Fed easing without signaling a deep downturn. Once the data begins to confirm actual economic slowdown or even a recession, then bad news becomes genuinely bad for small caps and cyclical stocks.

The question, then, is how sustainable the small-cap rally truly is.

"There's a narrow pathway where the labor market shows enough cracks to spook the Fed into cutting rates, but it doesn't necessarily spell the end to this [economic] expansion," Reynolds told MarketWatch via phone on Thursday.

"So far, nonfarm payrolls are looking just incrementally softer than we had seen a few months ago and the unemployment rate looks fine, so it's just some of the marginal information that's enough that the Fed just views higher risks there could continue to prompt them to ease," he said.

Are small caps still cheap - even at record levels?

To be sure, the recent rally has made small-cap valuations less enticing than they previously were. The iShares Russell 2000 ETF IWM was trading at a forward price-to-earnings ratio of 24.50 on Thursday, compared with 22.41 for the iShares Russell 3000 ETF IWV, according to Dow Jones Market Data.

But Reynolds and his team at Glenmede think valuations for small caps are still attractive "on a relative basis."

While small-cap stocks are currently trading at a modest 2% premium to their fair value, large-cap stocks appear significantly more expensive, with a 26% premium to fair value, according to a Glenmede calculation based on a blend of valuation metrics such as price-to-earnings ratio, price-to-cash-flow ratio, dividend yield and price-to-book ratio.

As a result, the valuation gap between the two is now roughly 24%, far above the historical average of 4%, Reynolds said. "Historically speaking, small caps are right about the 90th percentile of relative valuations," he added.

Joshua Schachter, chief investment officer and senior portfolio manager at Easterly Snow, noted that value stocks within the Russell 2000 are much cheaper in terms of valuation.

The iShares Russell 2000 Value ETF IWN on Thursday was trading at a forward P/E ratio of 18.18, according to Dow Jones Market Data.

"The Russell 2000 Value XX:RUJ is almost at the levels postelection in November. The Russell 2000 Growth XX:RUO is weighted more substantially with higher P/E stocks - so you're going to get higher valuations from the growth side, but the value side is much cheaper and the P/E ratio is much more attractive relative to the benchmarks," Schachter told MarketWatch in a phone interview on Thursday.

Rising Treasury yields remains a concern for small caps

Eric Stein, chief investment officer at Voya Investment Management, said that despite the stock market's ongoing momentum, the risk of rising Treasury yields BX:TMUBMUSD10Y remains a threat to the rally - particularly if the Supreme Court rules against President Donald Trump's tariffs, which could add to U.S. fiscal concerns.

Meanwhile, if Trump's aggressive tariffs lead to higher inflation, which might show up in upcoming earnings reports and inflation data, it could further pressure the Treasury market.

However, Stein noted that those risks are being counteracted right now because of the momentum in stocks, fueled in part by the Fed's pivot to at least a few rate cuts this year.

Stein said he also likes small caps. "I think we are in for a run in small-cap equities," he told MarketWatch on Thursday. "They have been lagging, they've started to pick up a little bit and they are interest-rate sensitive."