Small-cap stocks are currently presenting a striking opportunity for investors, particularly when compared to the soaring technology stocks that have dominated the market. However, caution is still warranted. Despite this, some experienced analysts on Wall Street are highlighting a unique chance to buy into small-caps, mid-caps, and other overlooked areas of the global equity market.
Disparity in Value
Among the many wise sayings on Wall Street, one stands out: cheap does not necessarily mean it will not get cheaper. Two equity strategists from Wall Street have suggested that small-cap stocks will likely face ongoing challenges as long as interest rates remain at or near their current levels.
Manish Kabra, head of U.S. equity strategy at French bank Société Générale, explains, “This trade is going to continue to be stretched until we see a strong positive Treasury yield curve and 100 basis points in Fed rate cuts.”
Profitability and Margins
Small-cap stocks face a significant obstacle: approximately one-quarter of Russell 2000 constituents are unprofitable. Even profitable companies in this category tend to have more modest profit margins compared to their large-cap counterparts.
Steve Sosnick, chief market strategist at Interactive Brokers, elaborates, “Many of the stocks in the Russell 2000 are marginally profitable or even unprofitable. It is logical for stocks that generate profit to outperform those that don’t.”
Hope on the Horizon?
Amidst the challenges faced by small-caps, there is a glimmer of hope provided by indications that the Federal Reserve might cut interest rates in 2024. Simultaneously, the ratio between the Nasdaq-100 and the Russell 2000 has recently reached a record high, according to Dow Jones Market Data.
The Russell 2000 had its best performance since February 2021 last week, as hopes of potential interest rate cuts by the Fed later next year sent stocks soaring. Interestingly, during this period, the small-cap index outperformed both the Nasdaq Composite and the S&P 500, which is a relatively rare occurrence.
In light of these developments, investors must carefully consider the current state of small-cap stocks before making any investment decisions. While opportunities may exist, it is essential to remain mindful of the potential risks and navigate the market wisely.
Small-Caps Struggling to Keep Up with Rebound Rally
Small-cap stocks, which had outperformed the Nasdaq in 2022, are currently missing out on this year’s rebound rally. According to David Rosenberg, founder of Rosenberg Research, the Nasdaq is currently outperforming the Russell by 32 percentage points in 2023, marking the largest margin of outperformance since the dot-com bubble in 1999.
Weakness in the Russell
The weakness in the Russell is widespread, with a majority of its components trading in bear-market territory. Data from Dow Jones Market Data indicates that 72.1% of the 1,970 stocks in the index are down 20% or more from their 52-week highs.
Valuations for small-cap stocks based on expectations for corporate profits are relatively low, although they have been lower in the recent past. The forward price-to-earnings ratio for the S&P 600 SML, a small-cap index excluding unprofitable companies from the Russell, stood at 12 on Wednesday. However, it had fallen as low as 8.7 in March 2020 and briefly dipped below seven in November 2008, according to FactSet data.
Despite their low valuations, these stocks are considered cheap but not completely bombed out.
Decreasing Small-Cap Outperformance
Nicholas Colas, co-founder of DataTrek Research, has shown that periods of small-cap outperformance have become less frequent over the past 20 years. In the past year alone, the Russell 2000 has underperformed the S&P by 19.7 percentage points, a level of underperformance described as highly unusual by Colas.
Conversely, stretches of S&P 500 dominance have become more frequent over the past two decades, with a growing margin of outperformance. Colas has illustrated this trend in a chart.
The Prospects for Small-Caps
Colas remains optimistic about the potential for small-cap stocks to make a comeback and even outperform big tech and other large-cap stocks. However, he advises clients to hold off on investing in small-caps for now, suggesting that year-end may be a better time to consider it.
In conclusion, while small-caps have struggled to keep up with the rebound rally this year, their valuations remain relatively low, and there is optimism for a potential comeback. Investors are advised to exercise patience before diving into the small-cap market.