Why Small-Caps May Finally Bust Out of Their Torpid State

Now is the time for small-cap stocks, so long in the doldrums, to take wing, according to Ronald Temple, chief market strategist at Lazard. The Russell 2000, the standard yardstick for small-caps, is up just 5.4% this year, trailing the 19% of the large-cap S&P 500. Small-caps are underpriced and due for a turnaround, he contended in a research note.

Small-caps typically surge after a recession, and there has been no such downturn recently, except for the brief, pandemic-propelled one in early 2020. But Temple argued in his research that things are different nowadays. Many strategists have opined that the pandemic and its economic fallout scrambled the rules.

He noted that another time small-caps ascend is when large-caps have gotten too expensive. One example was after the tech bubble burst in 2000. Temple wrote that in “the subsequent eight years (12/31/99–12/31/07), the Russell 2000 index delivered a total return of 69%,” or 6.8% annually. During that period, the S&P 500 advanced only 1.8% yearly.

In addition, the fact that the price/earnings gap between S&P 500 and the profitable companies in the Russell 2000 multiples are wide—they usually are closer together—suggests to Temple that small-caps, or at least many of them, are poised for better days.

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As he explained: “Since 2000, the trailing 12-month P/E ratio for positive earners in the Russell 2000 index has averaged 98% of the comparable multiple for the S&P 500 index. The lowest relative valuation was in June 2000 when the Russell 2000 P/E ratio was at 51% of the S&P 500 index. As of [September 30, 2023], the ratio stood at 59% after reaching 55% in May and June 2023.” Today, it remains around the September level.

Another reason Temple is bullish on small-caps: their heavily domestic focus. The Russell 2000 index constituents derive about 90% of their revenue in the U.S., compared with around 60% to 65% of the S&P 500’s revenue. “In our view, the domestic orientation of these companies should be a positive given the expected relative resilience of U.S. growth in 2024 and beyond,” Temple declared.

Finally, Temple pointed to the widespread expectation that the Federal Reserve will lower interest rates next year. That would be an outsized boon to small caps, which tend to be more heavily in debt than large companies. Some 45% of the Russell 2000’s members have floating-rate debt, compared with just 9% of S&P 500 companies, so small-caps would benefit most from a rate easing.

Not everyone agrees. Carrie Green, director of equities for the Tennessee Department of Treasury, took issue with the notion of an imminent small cap rebound. “Small-cap valuations are cheap for a reason.” Do not expect a turnaround any time soon, she warns.