Despite a challenging start to 2024, small-cap stocks in the U.S. have the potential to rebound and outperform as the Federal Reserve prepares to cut interest rates later this year. While representing only 6% of the U.S. equity market, these stocks have caught the attention of Wall Street analysts who believe that their recent rally could resume in the near future.
Small-Cap Stocks: A Promising Investment?
Acknowledging the disadvantages of small-cap stocks, such as weaker balance sheets and increased sensitivity to economic cycles, the analysts at UBS Group still see unique qualities that make them appealing in today’s market. As the Fed plans to reduce interest rates, small-cap stocks are expected to witness significant earnings growth. The UBS team forecasts double-digit earnings growth for companies in the S&P 600 SML small-cap index, a vast improvement compared to the aggregate earnings decline experienced in 2023.
Attractive Valuations and Market Inefficiencies
In addition to the earnings potential, small caps also offer relatively attractive valuations. The Russell 2000, for instance, is currently trading at approximately a 55% discount to the Russell 1000 RUI, surpassing its 10-year average discount of 32%. This valuation gap suggests an opportunity for investors seeking undervalued assets.
Moreover, delving into the world of small-cap stocks can provide intrepid investors with an advantage. Due to reduced analyst coverage, market inefficiencies are more prevalent in this space, creating room for potentially lucrative investments.
While small-cap stocks do come with certain risks, including less liquidity and a higher level of economic sensitivity, their potential for earnings growth and favorable valuations make them an attractive investment option amidst uncertain market conditions. As the Federal Reserve’s interest rate cuts loom on the horizon, acting swiftly may be necessary for those looking to capitalize on the potential gains offered by small-cap stocks.
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Bigger Payoffs in Smaller-Cap Stocks
Investors seeking higher returns may find significant potential in smaller-cap stocks compared to large caps. UBS analysts explain that the dispersion in performance is greater in smaller companies, largely due to their limited coverage by analysts. These inefficiencies can create opportunities for active managers to achieve above-market returns.
Additionally, investing in small caps can provide a layer of diversification to portfolios. According to UBS’s data, the correlation of U.S. small and mid-caps to the MSCI World index is around 0.52, indicating a moderate level of correlation. In contrast, large-cap stocks in both regions have a correlation of around 0.6. This distinction is crucial for portfolio diversification purposes.
While the swings in small-cap stocks tend to align with economic cycles, UBS believes that U.S. and European small caps, along with Swiss mid-cap stocks, would be among the primary beneficiaries in a scenario characterized by robust U.S. economic growth, slowing inflation, and preemptive interest-rate cuts by the Fed.
As of January, the Russell 2000 index has experienced a minor decline of 0.8% following a remarkable 13.5% rally during Q4 of the previous year. In comparison, the FANG+ index, which measures the performance of the largest megacap technology companies in the U.S., has achieved an impressive 7.4% increase in January alone. Throughout 2023, the returns for these two indexes were 96% for FANG+ and 15.1% for the Russell 2000.
On Tuesday morning, small caps were expected to open higher, primarily attributed to strong gains from Super Micro Computer Inc., the most heavily-weighted stock in the Russell 2000.
To provide context to these figures, it is worth noting that the S&P 500 has gained 3.3% since the start of the year, building upon a 24.2% increase in 2023, excluding dividends. The Nasdaq Composite has also performed well, achieving a 4.1% gain since January 1, following a substantial 43.4% gain in 2023. The Dow Jones Industrial Average, on the other hand, recorded a solid 13.7% increase last year and is currently up 1.7% in 2024.