Are Small Cap Stocks Making a Come back?

Historically, small cap stocks have had higher average returns than large cap stocks over the long run. However, Small-cap stocks have been underperforming larger ones for the second longest stretch since the 1930s. But there are signals that small-cap stocks may be coming out of their dark stretch. We are going to show you how to take advantage of todays historically cheap valuations on small cap stocks so you can position yourself to build wealth.

Since 1928, small cap stocks have outperformed large caps by nearly 2% per year.

Small cap stocks tend to outperform because investors demand a premium to invest in companies that are smaller and not as established as their large cap counterparts. Small caps tend to be more volatile as well, again, why investors demand a premium to invest in them. However, over the last 7 years we have seen significant outperformance by large cap companies mostly driven by the tech and AI boom and the Magnificent Seven. Take a look at this chart for a good visual.

However, the winds of change might be blowing.  With small cap stocks at historically cheap valuations relative to large caps, investors are shifting money as part of a strategy called "sector rotation," This strategy involves investing assets based on changes in the business cycle, with investors switching into different types of stocks based on trends like inflation and profit growth. 

Equity market leadership has experienced a dramatic shift in recent weeks. Small-cap stocks have enjoyed a significant rally. 

The most recent inflation report, which showed U.S. prices cooling faster than expected, spurred some investors to shift money into smaller stocks because of the expectation that the Federal Reserve could soon cut rates. That could provide an outsized benefit to these businesses since they are more reliant on borrowing than bigger companies.

According to a recent Wall Street Journal article quoted in the report, the forward price-to-earnings ratio for the S&P Small Cap 600 is 13x, as compared to 19x for the S&P 500 and 32x for the Magnificent 7. In other words, small caps are on sale. Would you rather buy that brand new pair of jeans for $200, or wait until it goes on sale and get it for $100? It’s the same phenomenon going on with small caps. The Magnificent Seven have gotten so expensive and we all know that trees don’t grow to the sky.

We believe the long period of underperformance of small-cap stocks is nearing an end. Starting points do matter, and the valuation gap between small cap and large cap is unusually wide by historical standards. There is, obviously, no way to pinpoint the exact turning point. We can, however, have some degree of confidence about that point coming soon. In the past, such a wide valuation gap has consistently resulted in outperformance of at least 5% annually for the following five-year period.

In the past, small caps often begin outperforming as the market begins anticipating Fed rate cuts. According to Morningstar, the Russell 2000 has risen an annualized 25.2 percent during periods of increasing growth and slowing inflation since the 1970s, outpacing the S&P’s 17.3 percent annualized gain in such environments.

With valuations at historical lows on relative and absolute terms, and numerous beneficial catalysts on the horizon, the opportunity set appears to be very constructive.

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This commentary reflects the personal opinions, viewpoints and analyses of the Seaside Wealth Management, Inc. employees providing such comments, and should not be regarded as a description of advisory services provided by Seaside Wealth Management, Inc. or performance returns of any Seaside Wealth Management, Inc. client. The views reflected in the commentary are subject to change at any time without notice. Nothing in this commentary constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Seaside Wealth Management, Inc. manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.