Might small be beautiful ... again?
After lagging their larger-cap brethren much of the year, small-cap stocks may be on the verge of taking the lead again. Federated is forecasting the economy to re-accelerate in the months ahead, a favorable environment for small caps because:
- Small companies tend to be more directly connected to the domestic economy than larger companies, which often have global sources of revenue. This makes small-caps more sensitive to economic changes in the U.S.—they tend to underperform more quickly heading into a recession and outperform more quickly during early periods of economic acceleration.
- Small-cap stocks generally are more volatile than larger-cap stocks, which can make them quicker to react to risk-on and risk-off periods in the markets. As the risk appetite picks up as the economy improves, typically the bid for small-cap stocks does too. Using Russell 1000, Russell 2000 and FactSet data, Merrill Lynch research dating from January 1990 through October of this year shows small caps have led large caps about 90% of the time during a transition from a slowdown such as we just experienced to a pickup that we expect is underway.
- Smaller companies tend to experience profit growth relatively quickly when economic growth accelerates, largely because of their relatively smaller overhead. This fits with Federated’s view that the profit slowdown over the past few quarters should give way to acceleration in the quarters ahead.
There are other reasons to like small caps. Despite negative headlines surrounding several large, high-profile companies that have recently gone public or plan to do so, the initial public offering (IPO) market remains robust. IPOs of companies with market capitalizations greater than $50 million have raised $43.6 billion so far this year, just shy of 2018’s $46.9 billion, which was the best year for IPOs since 2014, according to Renaissance Capital. Moreover, IPO companies this year have outperformed the broader market as represented by the S&P 500.
Further, small-cap valuations relative to large-caps are near 17-year low based on the P/E multiples for the Russell 2000 vs. the Russell 1000, with small-cap cyclical sectors particularly cheap. A perkier economy should give both a lift. And seasonally, small caps are in their sweet season—historically, they tend to do best from late fall through early spring. Merrill Lynch’s technical work also suggests small caps are due for a bounce, particularly in the value end of the asset class. Add it all up and there are good reasons to think small caps … again.