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From laggards to leaders: Small caps on the rise

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Is it finally time for small-cap and mid-cap stocks to overtake large caps’ long-time leadership?

Here are the year-to-date returns for major U.S. index ETFs:

Stocks driving that large-cap index performance include names you’ve become familiar with this year, such as Nvidia Corp. (NASDAQ: NVDA), Tesla Inc. (NASDAQ: TSLA) and Meta Platforms Inc. (NASDAQ: META), but also Royal Caribbean Cruises Ltd. (NYSE: RCL) and PulteGroup Inc. (NYSE: PHM).

What small-cap premium?

In recent times, large-cap stocks have been dominant despite an investing thesis called the small-cap premium. 

The small-cap premium refers to the historical tendency of small-cap stocks to outperform their larger counterparts over time. This phenomenon is attributed to the higher risk associated with smaller companies, leading to increased potential for growth. Investors typically expect a higher return from a smaller stock, in exchange for the additional risk of holding these less-established or less liquid companies.

However, large caps have thrived due to factors including higher borrowing costs, which are easier for large companies to absorb; the quest for income amid economic uncertainties; and the leadership of big techs, driven by AI in 2023.

Year-to-date, technology stocks in the Technology Select Sector SPDR Fund (NYSEARCA: XLK) and the Communication Services Select Sector SPDR Fund (NYSEARCA: XLC) have been the big leaders, although eight of the S&P sectors are up this year.

But is it time for a changing of the guard? Smaller stocks are trading at more attractive valuations, relative to larger stocks. That could draw investors looking for equities they can nab at less frothy levels. 

Small caps' favorable P/Es

A Bank of America November research report noted that the small-cap Russell 2000 forward price-to-earnings ratio fell to a 14-month low. It’s currently at 12.3 times forward earnings, down from 12.9 times. 

Meanwhile, the Russell MidCap P/E fell to 14.6 times forward earnings from 15.1 times. That’s now below the historical average. 

Large-cap valuations are also falling, as the Russell 1000 P/E fell to 17.3 times forward earnings, down from 17.9 times. However, small caps remain the cheapest size segment, trading at a 19% discount vs. historical levels, while mid-caps are also now cheap, trading at a 4% discount versus historical levels. 

When scouting for small-cap stocks, investors often have to research stocks that aren’t household names. 

Optimism about small biotechs

Analysts are bullish about several small-cap stocks in the healthcare sector.

For example, Avid Bioservices Inc. (NASDAQ: CDMO), Vir Biotechnology Inc. (NASDAQ: VIR) and Arcus Biosciences Inc. (NASDAQ: RCUS) are all expected to triple in price in the next 12 to 18 months, according to Wall Street forecasts. 

All of those small-cap biotech stocks are trading well below prior highs and there’s nothing bullish about any of those charts. In addition, biotech is a notoriously risky industry, with that risk amplified when you’re talking about small caps. 

Other factors are working in small caps’ favor. 

Of the SPDR Portfolio S&P 600 Small Cap ETF (NYSEARCA: SPSM) components that have reported third-quarter results, more than three quarters beat analyst estimates. 

Lower rates can boost small caps

In addition, if interest rates decline or remain stagnant, that’s a positive for small caps, as their cost of capital comes down, which bodes well for their growth.  

Finally, presidential election years frequently result in solid gains for small-cap stocks. 

In what’s possibly a preview of things to come, small caps outperformed their larger peers in the Thanksgiving-shortened session on November 24.

The SPSM ETF advanced 0.53% in the session, while the SPY ETF was up just fractionally.

Now, one holiday session doesn’t signal a trend, but the elements could be in place for smaller stocks to rotate into leadership. 

U.S. small stocks haven’t outperformed larger stocks since 2016, but asset classes eventually take leadership, even after years of underperformance.

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