After trailing large-cap stocks for a considerable period, small-cap stocks outperformed substantially in July: The Russell 2000 index posted a return of 11% versus flat to slightly negative returns for the S&P 500 and NASDAQ composite, respectively. As a result, the respective gaps in investment performance for the year narrowed substantially.
Much of the improvement occurred immediately after the June Consumer Price Index report was released, when the Russell 2000 index rose by 3.6% and the NASDAQ composite fell by 2%. It was the largest daily outperformance by small caps in more than four decades.
This development has caused investors to ask why it happened so suddenly and whether the outperformance can be sustained.
There is general agreement about the underlying factors. One explanation is that investors became concerned that leading artificial intelligence companies could not meet the high expectations of future earnings growth. They rotated into small-cap companies, where valuations on a relative basis are the cheapest in the past two decades according to Morgan Stanley (see chart below).
Relative PE Valuation: S&P 600 Small Cap Index / S&P 500 Index
Another catalyst was the favorable inflation report for June increased the likelihood that the Federal Reserve will ease monetary policy at the September Federal Open Market Committee meeting. Small-cap companies stand to benefit the most from Fed easing because they have a higher proportion of debt on their balance sheets than large-cap companies. They also have a higher percentage of debt that is floating rate rather than fixed rate.
Finally, some commentators have linked the strong small-cap results to polls showing Donald Trump is leading in the 2024 election and Republicans could sweep both houses of Congress. Following the 2016 election, small-cap stocks surged in anticipation of passage of the Tax Cuts and Jobs Act at the end of 2017. While Trump is pledging to extend it in 2025, one caveat is bond traders anticipate that inflation and bond yields could be higher if Trump wins because he also favors substantial increases in tariffs, I explained in a recent column for The Hill.
By comparison, there is a wide divergence in views about whether small-cap stocks will continue to outperform.
The principal reason small-cap stocks have lagged large-cap stocks since early 2023 is weak earnings growth. In a recent meeting with Jason Ronovech, senior portfolio manager for the Touchstone Small Company Equity Fund, he pointed out how there have been 24 months of negative earnings revisions for the S&P 600 index. S&P 600 earnings in 2024 are forecast to be 15% below 2022 levels, while S&P 500 earnings are forecast to increase 13% over the same period.
The encouraging part of the story is that the earnings growth expectations for small caps in 2024 are undemanding as long as nominal gross domestic product growth is about 5% and pricing power and margins hold up. Also, while small-cap valuations increased after the July rally from multidecade lows relative to large caps, they remain at an attractive 25% discount compared to parity on average over the last 25 years.
Michael Cembalest, chair of market and investment strategy for J.P. Morgan Asset & Wealth Management, provided a long-term assessment of the asset class in a recent commentary. His take is while small-cap stocks generated tremendous outperformance from 1930 to 2010, the asset class has underperformed considerably since then because small cap stocks have several unfavorable characteristics including: lower free cash flow margins; considerably more companies with negative earnings; lower returns on invested capital; and higher debt-service costs.
Looking at sectors of the small-cap market, Cembalest believes a key reason for the underperformance is small-cap tech stocks have lagged large-cap counterparts by a factor of three times since 2010. During the last five years, the tech weight of small-cap stocks has declined significantly, whereas it has surged in the large-cap index. That said, no small cap sector has meaningfully outperformed its large-cap counterpart since 2010.
Weighing these factors, what is the case for investors to add small-cap exposure now?
My take is that the case for doing so is primarily based on relative value and diversification considerations. At a time when the market cap of the “magnificent seven” mega-cap stocks is more than 30% of the S&P 500 index, the share of small-cap stocks in the Russell 2000 index has fallen to less than 3% of all U.S. market capitalization. Consequently, the asset class is appealing for investors who are looking for good relative value.
Amid the uncertainty about the U.S. economic outlook, small-cap stocks offer two benefits. First, they could outperform large-cap stocks if the U.S. economy grows at a solid pace because they are more levered to the economy. They also stand to benefit if inflation continues to fall toward the Fed’s 2% target and it eases monetary policy in the balance of this year and next year.
Finally, another consideration is the asset class is less efficient than large caps because there is considerably less coverage of names by analysts. This is especially the case for portfolio managers who use the Russell 2000 benchmark, where there are no requirements that companies have positive earnings.
By comparison, some managers construct higher quality portfolios that look more like the S&P 600 index. In this regard, Cembalest presents data showing that manager selection was able to offset some, but not all, of the underperformance of small caps relative to large caps.
For this reason, it is imperative for investors to understand the investment processes that small-cap portfolio managers use to beat their benchmarks.
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