Displaying items by tag: small caps

Investors are increasingly turning their attention to small-cap stocks and ETFs due to a combination of favorable valuations, historical trends, and recent market dynamics. This renewed interest has been highlighted by a significant rally in small-cap stocks, particularly during July when the Russell 2000 recaptured much of its earlier underperformance relative to large-cap indices. 

Analysts suggest that small-caps are still undervalued, with some estimates indicating a 20% to 30% discount compared to larger stocks. This presents a potential opportunity for prolonged outperformance in the small-cap sector. Notable options include the iShares Russell 2000 ETF (IWM), which tracks a broad index of small-cap companies, and the Vanguard Small-Cap Value ETF (VBR), which focuses on value-oriented small-cap stocks.

 Each of these ETFs provides investors with a strategic entry into the small-cap market, with varying levels of risk and potential return depending on their investment goals.

Finsum: Also note that as interest rates come down small caps are historically in a position to take advantage because they are more levered. 

2024 has continued 2023’s trend of growth outperforming value. YTD, the iShares S&P 500 Growth ETF (IVW) is up 15%, while the iShares S&P 500 Value ETF (IVE) is up only 6%. For many investors and portfolio managers, this presents an opportunity to increase exposure to high-quality, value stocks. 

NewEdge Wealth CIO Cameron Dawson sees risk with many growth stocks given ‘nosebleed valuations’. However, he believes that there are value stocks with strong balance sheets and cash flow that still have growth potential, specifically in semiconductor supply chain stocks, and older growth stocks that have now matured into value stocks like eBay or Broadcom.

Another approach is to look at ‘unloved sectors’. Examples include utilities, materials, financials, and energy. These have underperformed in the last couple of years amid an environment of higher rates and decelerating global growth. If financial and economic conditions start to improve, then these sectors could enjoy strong rallies. Housing is another interesting area for value investors, given strong fundamentals due to demographic-driven demand and limited supply in addition to attractive valuations. 

According to history, small-cap value stocks tend to outperform during this part of the market cycle. Eric Leve, the CIO of Bailard, sees the next group of AI winners emerging from this category with particular upside in software-as-a-service and cybersecurity stocks. 

Finsum: Value investing is certainly out of favor given the massive outperformance of growth over the last few years. Yet, many investors and portfolio managers see this as an opportunity to increase exposure and de-risk and diversify their portfolios.

There was an inflection point for financial markets in October. Soft inflation data resulted in a change in consensus as Fed futures now indicate that the Fed’s next move is more likely to be a rate cut rather than a hike. One of the biggest winners of this dovish shift has been small-cap stocks as the Russell 2000 is up 12.1% over the last 90 days and 8.5% over the past month. Another reason for interest in the sector is that valuations are at historically low levels.

In theory, rate cuts are bullish for small-cap stocks since they lead to lower financing costs, puts upward pressure on multiples, and tends to be a leading indicator of an increase in M&A activity. In reality, rate cuts are often necessary due to a weakening economy. Thus, a major variable in whether small-caps deliver stellar returns is whether inflation can continue to moderate without the economy tumbling into a recession. 

According to Mike Wilson, CIO and chief US equity strategist for Morgan Stanley, investors should pay close attention to earnings revisions, high frequency economic data, and small business confidence. At the moment, all of these measures are moving in the wrong direction. He adds that for small-cap outperformance to continue, GDP needs to reaccelerate, and inflation needs to stabilize at current levels. 

Finsum: After years of underperformance, small-cap stocks are seeing huge gains on rising odds of a Fed rate cut next year. However, continued outperformance for the sector depends on certain variables.

Small-cap stocks appear to be having their moment this year outperforming their large-cap peers. The S&P 600 small-cap index is currently on pace to outperform the S&P 500 for the first time since 2016. One reason for their outperformance is a strong U.S. dollar. This is due to the negative effect that a strong dollar has on the profits of multinational companies. A strong dollar harms U.S. companies that sell goods overseas by making them less affordable. Smaller companies, on the other hand, are more insulated from adverse currency effects as most of their business is done stateside. For instance, companies in the S&P 600 index generate only 20% of their revenue outside the U.S, while companies in the S&P 500 generate 40% of their sales abroad. This had led to some of the largest companies in the U.S warning of currency risks in their latest earnings calls. In addition to a strong dollar, small caps are also benefitting from better valuations. According to FactSet, the S&P 600 is trading at 10.8 times expected earnings over the next 12 months, which is well below the S&P 500’s forward price/earnings ratio of 15.3.

Finsum: Small-cap stocks are outperforming large-cap stocks this year due to a strong U.S. dollar and more attractive valuations.

Based on research released Monday, Lori Calvasina, head of U.S. equity strategy at RBC Capital Markets, believes that small-cap stocks have already priced in a recession and are currently de-risked. Calvasina noted that small-cap performance has been stable since January and is in a narrow trading range in comparison to large-caps. She stated, “While this doesn’t necessarily tell us that a bottom in the broader U.S. equity market is imminent, it does tell us that the equity market is behaving rationally. It has been our view for quite some time that small-caps, which underperformed large-cap dramatically in 2021, have already been de-risked and are baking in a recession.” She also pointed out the sectors that tend to perform best in the period leading up to the final rate increase in a rate-hike cycle. These include defensive sectors such as consumer staples, energy, financials, healthcare, and utilities. Calvasina wrote the sectors “tended to perform the best within the major index in the six-, three- and one-month periods before the final hikes in the past four Fed tightening cycles.”

Finsum: In a recent research note, Head RBC equity strategist Lori Calvasina believes that stable returns of small-cap stocks are due to recessionary factors already priced in.