Understanding Why Small-Caps Are Disappointing

There’s no denying that small-cap stocks are in the midst of a lengthy run of disappointment relative to large-cap counterparts. For three years ending June 11, the S&P 500 returned 33.1% while the Russell 2000 and S&P SmallCap 600 indexes posted an average loss of 6.7%.

Some of small-caps’ laggard status is attributable to the interest rate hikes deployed the Federal Reserve in 2022 and into 2023. Broadly speaking, smaller companies are more capital-intensive and that elevated need for financing creates much of the asset class’s rate sensitivity. Inflation, which caused those high rates, has also been a drag on small-cap growth companies, weighing on broader smaller equity strategies in the process.

Then there’s the technology problem. As in the Russell 2000 and the S&P SmallCap 600 have an average weight of 14.15% to the tech sector while the large-cap S&P 500 devotes 31.15% of its weight to that sector.

Still, smart advisors and investors know these factors should be priced into small-caps at this point (they probably are) and with the asset class trading at historically depressed valuations against large-caps, it’s arguably frustrating there’s not more momentum for smaller equities. Some experts believe that scenario is poised to improve.

Anticipation Could Be Advantageous

To this point in 2024, the Fed has disappointed by not lowering interest rates and even under the most optimistic assumptions, the central bank could pare borrowing costs twice before the end of the year. Entering this year, consensus called for anywhere from three to six cuts and there’s still a possibility none will come to pass until 2025.

While it might be viewed as little compensation to some investors, the other reality is that it’s probable the Fed is done tightening, meaning it’s appropriate to anticipate cutting and that anticipation should be supportive of smaller stocks.

“Small cap generally outperform markets, large companies when there is an anticipation of Fed rate cuts,” said Keith Lee, lead portfolio manager on the Brown Capital Management Small Company Strategy, in an interview with Morningstar. “I think Morningstar has said that the Russell 2000 has risen about 25% during periods of increasing growth and slowing inflation since the ‘70s versus about 17% for the S&P.”

Lee did mention the valuation gap between large- and small-caps, noting the S&P 500 trades at 19x forward earnings while that figure declines to 13x for the S&P SmallCap 600.

Valuation Should Matter

Valuation alone isn’t a reason to get involved, but as noted above, things are getting interesting in the small-cap space. The data cited below is about a month old, but it hasn’t changed much and underscore the point that smaller stocks are unusually cheap.

“Also, small-cap stocks are cheaper compared to the S&P 500. Since 1995, small stocks delivered a 3% valuation premium on average because of their higher long-term returns,” reported Lucas Downey for FXEmpire. “Currently, small-cap stocks trade at a 27% discount relative to the S&P 500. They’ve rarely been cheaper.”

That is to say patience could be rewarded with small-caps. Eventually.

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