PERSPECTIVE3-5 min to read

Could the tide finally shift to small caps?

Numerous signs suggest the potential for a resurgence of small-cap stocks.

20/03/2024
US-outlook-2023-epi

Authors

Bob Kaynor
Head of US Small & Mid Cap Equities

Predictions that the reign of US large-cap stocks will soon draw to a close may seem hollow, given that large-cap stocks have been on an extended run of outperformance. Over long timeframes, though, the market has always been cyclical, and there are a number of good reasons to believe there will eventually be a resurgence in the performance of small-cap stocks, perhaps at some point later this year or early next.

1. Declining interest rates is an especially favorable climate for small caps.

While the cost of refinancing debt becomes especially expensive for small-cap companies in periods of rising interest rates, given that much of their debt is structured with shorter-term and floating-rate instruments, that fact also makes a period of declining interest rates particularly favorable for small caps.

The conditions in the US that could lead the Federal Reserve (Fed) to begin cutting rates – slowing inflation and below-trend growth – have historically been a climate in which small caps have outperformed large-cap stocks, bonds and commodities.

Figure 1: In the post-World War II period, small caps have outperformed most other asset classes in periods of slowing inflation and weak economic growth1

611895_Web_charts_v2_Figure 4 - FINAL

Note: US dollar (USD) since 1967, West Texas Intermediate (WTI) crude oil since 1947. Russell 2000 Index for small-capitalization stocks from 1979 on. Prior to 1979, the source of historical returns was the CRSP®, the Center for Research in Security Prices, Graduate School of Business at the University of Chicago. Used with permission. All rights reserved. www.crsp.uchicago.edu. Past performance has been calculated by BofA Equity & Quant Strategy. Source: Haver, Bloomberg, Global Financial Data, DOE, CRSP, BofA US Equity & US Quant Strategy. Shown for illustrative purposes only and should not be interpreted as investment guidance. Past performance provides no guarantee of future results and may not be repeated.

2. Historically, small caps’ reign of outperformance has lasted, on average, for 10 years.

The outperformance of large caps over their smaller counterparts has lasted for so long, it can be  tempting to believe that it is the new, permanent state. That may seem especially the case given that, in recent years, every time small-caps looked ready to make a comeback, their rally proved to be short-lived and large caps reasserted their dominance. History suggests, though, that the market is cyclical. When small caps do begin to outperform, their reign could be prolonged, given that, in the past, their phase of the cycle often lasted as long 10 years.

Figure 2: Small cap relative performance cycles tend to last about a decade1

611895_Web_charts_v2-FIGURE 1

Source: CRSP®, the Center for Research in Security Prices; BofA Equity & Quant Strategy. Source of Historical Returns: CRSP, Graduate School of Business at the University of Chicago. Used with permission. All rights reserved. www.crsp.uchicago.edu. Past performance has been calculated by BofA US Equity & Quant Strategy. Shown for illustrative purposes only and should not be interpreted as investment guidance. Past performance is not a guide to future results and may not be repeated.

3. Expectations of a strong earnings recovery.

The Fed’s continuing interest rate hikes and the ripple effects of Silicon Valley Bank’s collapse made 2023 an especially difficult year for small-cap stocks. But the consensus Wall Street estimates for 2024 are that small caps will experience an even more dramatic earnings recovery than large caps do.

Figure 3: Wall Street forecasts a bigger earnings rebound for small caps

Quarterly year-over-year bottom up earnings-per-share growth trajectory for S&P 600 vs. S&P 500 (consensus estimates for 4Q23 onward)

611895_Web_charts_v2_Figure 3

Source: FactSet, Schroders. There is no guarantee the forecast will be realized.

Given that the relativeness cheapness of small caps has been used, for several years now, as a reason to believe their rebound was imminent, we won’t try to make a case for their recovery on a valuation basis. That being said, though, it still remains worth noting that small caps remain at historically low levels of cheapness relative to large caps.

Figure 4: Small caps remain historically cheap vs. large caps1

611895_Web_charts_v2_FIGURE 2 - final

Source: Bank of America US Equity & Quant Strategy, Russell Investment Group, I/B/E/S, Compustat. Shown for illustrative purposes only and should not be interpreted as a recommendation to invest in any asset class. Current performance trends are not a guide to future results and may not lead to favorable investment opportunities.

Beyond the numbers, a convergence of favorable trends.

Broad economic and societal trends, occurring both in the United States and globally, could also favor small caps. As we’ve discussed in the past, services are taking up an increasingly larger share of the US economy, relative to consumer goods. Small-cap companies operate much more in the service economy and don’t generally compete with the megabrands that produce consumer goods. Deglobalization is also occurring because companies don’t want to again experience the risks to their supply chains that became so evident during the pandemic, particularly with the prolonged shutdowns in China. Small-cap companies could be the prime beneficiaries of the move to onshore and near-shore vendor relationships. Onshoring is also one of the factors – along with increasing automation and the fiscal stimulus provided by the CHIPS and Science Act and the Inflation Reduction Act – that are contributing to increases in all companies’ capital expenditures, and small companies’ revenue growth is highly correlated to capex.

An additional opportunity for diversification and risk management

While no one has a crystal ball that will reveal when the inevitable market rotation to small caps might begin, it’s also important to recognize the risks that the stellar performance of the “Magnificent Seven” have created. The exceptional returns posted by the S&P 500 Index after the market decline of 2022 have been mostly limited to the gains made by Alphabet, Amazon, Apple, Meta Platforms, Microsoft, NVIDIA and Tesla. The market has reached a historic level of concentration, and that poses a considerable risk. Beyond the return potential a rebound in small caps would offer, owning companies across the capitalization spectrum could also provide a level of diversification and risk management that portfolios heavily allocated to large caps might now need.

Resources:

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The views shared are those of the Schroders investment team. The material is not intended to provide, and should not be relied on for accounting, legal or tax advice. Information herein has been obtained from sources we believe to be reliable but Schroders Plc does not warrant its completeness or accuracy. No responsibility can be accepted for errors of facts obtained from third parties. Reliance should not be placed on the views and information in the document when taking individual investment and / or strategic decisions. The opinions stated in this document include some forecasted views. We believe that we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee that any forecasts or opinions will be realized. This document does not constitute an offer to sell or any solicitation of any offer to buy securities or any other instrument described in this document. Past performance is no guarantee of future results.

Authors

Bob Kaynor
Head of US Small & Mid Cap Equities

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