A rally in the closing months of 2023 highlighted small caps’ potential to generate strong returns, however since the start of the new year, the asset class has reversed course.

 

Today we’ll examine prospects for the small cap sector in 2024.

 

After sprinting toward the finish line in late 2023 as one of the strongest areas of the U.S. equity market, small-cap indexes have come off the blocks slowly so far this year. The S&P SmallCap 600 and Russell 2000—the two main small-cap indexes—surged 23.3 % and 23.8 %, respectively. This followed a long stretch of disappointing returns and underperformance relative to large-cap indexes like the S&P 500 and Russell 3000.

 

During the rally, money poured into small caps and asset managers hurried into the segment, according to fund flow and positioning data. Views from institutional investors quickly swung from bearish to rather bullish.

 

RBC Capital Markets, LLC’s Head of U.S. Equity Strategy Lori Calvasina wrote, “In December it felt like everyone we met with (including the many varieties of investors who are not focused on small cap investing) wanted to talk about small caps and was constructive on them. We can’t remember the last time this happened.”

 

But in the first three weeks of January, small caps have rapidly given back about one-third of their late-2023 gains and underperformed the S&P 500, prompting a debate about whether the sub-asset class has staying power.

 

Small Cap Investing carries increased volatility (and elevated risk). The recent pullback underscores the view that patience is needed regarding the small-cap portion of portfolios.

 

Small Caps Have Some Winning Attributes:

• Valuations look attractive. The S&P SmallCap 600 trades near 20-year lows relative to the S&P 500 on a trailing price-to-earnings (P/E) basis. It also trades at a notable relative discount when forward earnings estimates are taken into consideration, and its trailing and forward P/E valuations are below its own historical averages. Based on price-to-sales metrics—which we think are more important for small caps—both indexes look reasonable to us, sitting near their long-term averages.

 

• They typically do well during Fed easing cycles. Since the late 1970s, small caps have tended to trade higher when the Fed cut interest rates and have struggled more often than not when rates rose, according to Calvasina. The Fed is likely to start cutting rates in the middle of this year.

 

• Balance sheets and funding issues seem better than feared. Fallout from the Fed’s aggressive rate hike cycle weighed on small caps for much of last year, amid concerns that higher rates on debt issuance and loans could meaningfully constrain balance sheets. Small-cap companies are more dependent on external funding than their large-cap peers. But Calvasina’s data indicate the debt situation for small-cap companies as a group is better than it could have been, as they have increasingly shifted to long-term funding. The effective interest rate for Russell 2000 companies was between 4.8 % and 5.1 % as of December 2023. This is still well below average funding costs since 1989 and somewhat below the average since 2003.

 

• Their portfolio diversification benefits go beyond just size. Sector weightings differ meaningfully between large-cap and small-cap indexes. Information Technology and Communication Services have much higher weightings in the S&P 500, whereas economically sensitive (cyclical) sectors like Industrials, Financials, Consumer Discretionary, and Real Estate have higher weightings in the small-cap indexes, as the table illustrates. Also, the 10 largest stocks in the S&P 500 represent a significant 30.9 % of that index (“Magnificent Seven” tech-oriented stocks), whereas the 10 largest stocks in the S&P SmallCap 600 and Russell 2000 represent only 5.8 % and 3.3 %, respectively. Therefore, the latter are much more diversified. But we think patience is needed

 

• Small caps tend to underperform during periods of low GDP growth. Currently, RBC Economics and the Bloomberg consensus forecast are calling for below-average U.S. GDP growth in 2024. Small-cap stocks typically underperform in such environments because they have a greater share of cyclical stocks, and earnings and revenue growth are harder to come by when the economy is sluggish. They tend to perform better when GDP growth is above trend, especially in the early stages of a growth cycle coming out of a recession.

 

• If a hard landing materializes, they could trade back down to previous lows. The Russell 2000 was fully pricing in a recession at its low point last October, according to Bloomberg Intelligence. If the consensus forecast for slow growth this year is wrong and a recession begins, small-cap indexes could fall back to those lows.

 

A moderate Overweight position in U.S. small caps is warranted due to the steeply discounted valuation relative to large caps. Be cognizant that an unusually wide range of plausible economic outcomes in 2024 could impact small caps’ earnings and revenue growth. Which is why small caps will likely experience ups and downs this year. Investors should take a patient approach.

 

If you have any questions or comments, please feel free to let me know.