Can small-caps continue to rally?

Investors love a story. It gives us a reason to get busy and do something (despite the overwhelming evidence that nine times out of ten sitting on our hands serves us better). And there’s no better call to action for a restless investor than a good old-fashioned rotation - sell what you’ve got and buy something shiny and new.

The past couple of weeks have served up the mother of all rotations. Since 9 July the Russell 2000 Index of smaller US companies has risen by just shy of 10 per cent, while the S&P 500 Index of America’s biggest stocks has gone nowhere. The mega-cap dominated blue chips have beaten the out of favour small-caps on almost any time frame over the past 20 years. But then, out of the blue, the prevailing market narrative has been turned on its head. Two questions arise. What caused this dramatic U-turn and can it last?

Two main factors coincided a fortnight ago to turbo-charge the small cap rebound. First, US inflation emerged lower than expected and cemented market expectations for a September interest rate pivot by the US Federal Reserve (Fed). Lower interest rates are good news for smaller companies, which tend to have greater borrowings relative to their size and so are particularly sensitive to changes in the cost of money.

Second, the odds on Donald Trump returning to the White House shifted in his favour. The market thinks a Trump presidency would deliver lower taxes, which again disproportionately helps less profitable smaller companies.

These two events reinforced an already good case for rebalancing a portfolio away from the handful of giant technology stocks that have fuelled the market’s near-two-year bull market and towards the market’s forgotten small caps. The latest earnings season has seen a broadening out of profit growth from the Magnificent Seven to the rest of the market. And the valuation gap between the two groups of companies has widened significantly.

At the bottom of the market in October 2022, the S&P 500 was valued at 16 times reported earnings versus 15 times for the equal weighted version of the index. Today the benchmark is valued at 25 times earnings, compared with 18 times for the equal weighted index. Measured against sales, small-caps are cheaper relative to larger companies than at any point in the past two decades.

So, it’s easy to see why small caps might have rallied. Can the outperformance last? The first caveat is that we’ve been here before, and not so long ago. Rewind to the last two months of 2023 and there was a similar rebound for smaller companies on the back of speculation about an imminent start to the Fed’s rate-cutting cycle. Between the end of October and Christmas, the S&P 500 rose by 16 per cent while the Russell 2000 added 26 per cent over the same period. By the end of January, however, the gap had almost closed as investors decided they had got over their skis.

A second reason not to overstate the changing-of-the-guard narrative is that investors are not really selling the mega caps. The AI and cloud computing story remains intact; earlier this week, Alphabet unveiled another encouraging quarter of growth. So, the defensive qualities of the largest stocks continue to look attractive in the face of an apparent slowdown. There is, after all, a reason why the Fed is looking to cut interest rates.

Large caps will benefit from falling interest rates too, and the majority of recent inflows have gone into these more liquid stocks. At the same time, an inflationary policy platform of tariffs and immigration curbs could be bad for consumer sentiment, to which domestically focused smaller companies are particularly exposed.

Despite these concerns, the pendulum has clearly swung a long way in favour of large caps and the recent rally has done little more than slow that trend. At the end of 2020, after the initial post-pandemic bounce, the ratio of the Russell 2000 Index to the S&P 500 was 0.6. On the eve of the recent US inflation announcement ,it had reduced to just 0.36 and even now it has risen only to 0.4. Arguably the catch-up has only just begun.

If the rotation into small caps does have legs, what might it mean for investors? Two things, I think.

First, it could be good news for stock pickers. Active investors have had a tough time of it while markets have been dominated by the Magnificent Seven. Such is the relative weight of these stocks, that anyone trying to do more than mirror the index has found it almost impossible to keep up. They may find it easier to do so in a more broad-based market.

The second positive consequence could be that investors continue to grow the value of their portfolios, even in the face of a fall in the headline level of the market. With 75 per cent of S&P 500 stocks now higher than their 200-day moving average, it is possible that we experience a re-run of the period after the bursting of the dot.com bubble. Then, an investor in so-called old economy shares was able to keep their head above water, despite a sharp drop in the overall market.

Much depends on whether we see a re-allocation of existing money out of mega caps and into smaller companies or a broadening out of the rally that will pull new money into the market on the back of the Goldilocks scenario of falling interest rates and robust economic and earnings growth. The latter would give the rotation story a happier ending.

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Please note that the views expressed in this article are my own.