Perspectives

Highlights:

• In recent years, small cap stocks have largely been overshadowed by
  their large cap counterparts, with investors focusing on the impressive
  gains of mega-cap technology names.
• The outlook for small cap stocks looks constructive, supported by
  the prospect of robust earnings growth, attractive valuations,
  improving market breadth, and a favorable economic backdrop.
• International small caps may also be worth a look based on prospects
  for superior earnings growth against a backdrop of attractive
  valuations.

Revisiting the Case for Small Caps

As investors seek opportunities in the current market landscape, small cap stocks have emerged as a potentially overlooked and undervalued asset class. Despite recent challenges, the outlook for US small caps in the coming years looks increasingly constructive. This piece will explore the key reasons behind the optimistic outlook and why investors should consider allocating to small caps.

Reasons for Favorable Small Cap Outlook

1. Earnings Recovery and Growth: Small cap earnings are expected to rebound strongly next year, with growth rates potentially outpacing their large cap counterparts (Figure 1). As the economy recovers from a Fed-induced slowdown, smaller companies are well-positioned to benefit from the uptick in consumer spending and business activity. The improving profit picture bodes well for small cap performance.
2. Attractive Valuations: Small caps are currently trading at a significant discount to large caps, both on a historical basis and relative to their growth prospects (Figure 2). This valuation gap suggests that small caps may be underappreciated by the market, presenting an attractive entry point for investors. As the earnings recovery gathers pace, there is potential for valuation multiple expansion, further supporting small cap returns.
3. Scope for Improving Market Breadth: Recent equity market advances have been extraordinarily narrow, as seen in the notable underperformance of the S&P 500 Equal Weight Index compared to the more familiar cap-weighted S&P 500 Index (Figure 3). That reflects the extreme outperformance over the past year of a handful of mega-cap stocks fueled by investor enthusiasm for the AI revolution. Historically, extremely narrow market advances have been followed by more broad-based market gains and outperformance of small caps, especially over longer horizons like 3 or 5 years (Figure 4).
   
4. Monetary Policy and Economic Recovery: The Federal Reserve has recently dialed back its dovish stance, but potential rate cuts remain on the horizon for this year and next. Lower interest rates and accommodative monetary policy have historically been supportive of small cap stocks (Figure 5). Additionally, as the economy rebounds from tight monetary policy, small caps are likely to benefit from the cyclical upturn, given their greater sensitivity to economic conditions compared to large caps.
5. Reshoring and Capex Beneficiaries: The trend of reshoring, or bringing manufacturing back to the US, is expected to continue in the coming years (Figure 6). Small cap companies, particularly those in the industrial and manufacturing sectors, stand to benefit from this shift. Moreover, the anticipated increase in capital spending as businesses invest in expansion and productivity enhancements could provide a boost to small cap earnings.

International Small Cap Also Deserves a Look

Many of the same factors that could favor US small caps could also help International small cap stocks outperform their large cap counterparts in the coming years. Bottom-up analyst earnings forecasts for international small cap stocks are less rosy than those for US small caps, but still anticipate faster earnings growth for small caps over the next three years than for large caps (Figure 7).

Like their US counterparts, international small caps are also trading at a significant discount to large caps (Figure 8). The implication is that international small caps may be underappreciated by the market, with multiple expansion a logical outcome if they proceed to post superior earnings compared to international large caps.

One wild card that could boost the relative performance of international small caps is the value of the US dollar, which we recently argued is overvalued and ripe for a multi-year correction.¹ There has historically been a very strong correlation between dollar strength and outperformance of US large cap stocks relative to international small cap stocks (Figure 9).

Simply by depressing the dollar value of non-US companies’ earnings, the strong dollar over the past decade has disadvantaged international small cap stock performance. A reversal of that trend would tend to boost the dollar value of international small caps earnings, especially favoring non-US companies with domestic exposure whose profits are relatively immune to exchange rate fluctuations.

Risks and Considerations

While the outlook for small caps is promising, investors must also be aware of potential risks. One key concern is the impact of rising interest rates on highly leveraged small cap companies. Those with significant debt burdens may face challenges in refinancing or servicing their obligations, which could weigh on their financial performance. Additionally, credit conditions and spreads bear monitoring, as any deterioration could disproportionately affect small caps.

Another risk factor to consider is the potential for increased volatility in the second half of 2024, given the uncertainty surrounding the US presidential election. Small caps have historically been more sensitive to market volatility, and the election outcome could have significant implications for various sectors and industries.

With both major candidates likely to support increased deficit spending, higher-for-longer interest rates could provide a headwind to US small caps, which have roughly 40% of their debt tied to short-term rates (Figure 10). Non-US equities could face a headwind from potential large across-the-board tariff hikes proposed by Donald Trump. That said, the negative impact on non-US firms’ export revenues will probably be greater for large cap export firms than for more domestically focused small caps.

Navigating the Small Cap Landscape

To capitalize on the small cap opportunity while mitigating risks, investors should focus on quality companies with strong fundamentals and sustainable growth prospects. Investors should also be selective in their sector allocation within small caps. Sectors such as industrials and consumer discretionary may be well-positioned to benefit from the economic recovery and reshoring trends. However, sectors with higher leverage and interest-rate sensitivity, such as financials and real estate, warrant caution.

Conclusion

The outlook for US small cap stocks looks increasingly constructive, supported by the prospect of robust earnings growth, attractive valuations, improving market breadth, and a favorable economic backdrop. While risks such as interest-rate concerns and election-related volatility persist, investors who are selective and focus on quality companies can potentially reap the rewards of small cap outperformance.

As the market enters a new phase of the cycle, small caps are poised to take a leading role. Investors who allocate strategically to this asset class may be well positioned to capitalize on the compelling opportunities that lie ahead.

William P. Sterling, Ph.D.

Global Strategist