Through the first half of 2023, one of the most often lobbed criticisms — an accurate one at that — of the equity market rally was that it was highly concentrated in a small number of mega-cap growth stocks.
Speaking of star stocks, as recently noted by Bank of America strategist Michael Hartnett, just seven names account for 84% (as of May 30) of the Nasdaq 100 Index’s (NDX) upside this year. They are as follows: Apple (AAPL), Alphabet (GOOGL, GOOG), Microsoft (MSFT), Amazon (AMZN), Meta (META), Tesla (TSLA), and Nvidia (NVDA).
Translation: There wasn’t much in the way of contributions from smaller stocks in the first six months of the year, be they smaller large-cap names or mid- and small-cap equities. Look now because, specific to small-caps, things are turning for the better.
Over the past 90 days, the Russell 2000 and the S&P SmallCap 600 indexes are higher by 14.3% and 13.8%, respectively, while the large-cap S&P 500 is up 10.7%. That’s not a bad sign for the S&P 500. Rather, it’s encouraging that more stocks are getting in on this bull market.
Good Time to Size Up Small-Caps
Advisors know this, but owing to the mega-cap growth stocks looming so large in terms of return contributions for the past decade-plus, many clients don’t realize small-caps are actually the winners over lengthy holding periods.
“Now, while it’s true that small-caps have underperformed as of late, history suggests that won’t be the case for long. Small-cap stocks have outperformed their large-cap counterparts in eight of the past 10 decades,” observes Nationwide’s Mark Hackett. “What’s more, small-caps have outperformed large-caps by an average of 6% per year since 1927.”
Obviously, it takes time for such scenarios to play out in clients’ favor, but there’s another reason smaller stocks are near-term relevant. The asset class is underappreciated inflation-fighting credibility. That’s something to consider because, although inflation is easing, the Federal Reserve could well make 3%, not 2%, its desired inflation range.
“In fact, small-caps are the only asset class to outperform inflation in every decade. One reason for that consistent performance year after year is that smaller companies are usually more nimble and able to react more quickly to increases in the cost of doing business,” adds Hackett. “This allows them to remain profitable in the face of inflation and rising rates by reducing their operating expenses and increasing their prices if necessary.”
Another benefit of accessing small-cap stocks in passive fund form is that these products are generally more diverse than their large-cap equivalents. For example, no member of the Russell 2000 exceeds a weight of 0.63% and the index’s top three sector allocations combine for about 49% of the index’s weight. Conversely, Apple alone commands 7.51% of the S&P 500 and the top three sector weights there combine for 55%.
Dodged Recession Good for Small-Caps
There’s been ample debate regarding the U.S. economy’s recession prospects, talk of a technical recession, etc. What’s not up for debate is the point that, owing to their domestic focus, small-caps are vulnerable to economic contraction.
Conversely, smaller stocks perform well coming out of a recession – something to consider today as banks and economists dial back recession expectations. Plus, smaller equities are attractively valued.
“And right now, small-caps remain relatively attractive. How attractive? The current dynamics of today’s market have brought small-cap stocks to valuations that are not only historically low relative to large-cap stocks, but also attractive purely on an absolute basis,” concludes Hackett.
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