Where to from here for US small caps?

There is no denying they have been the ugly stepsister of share markets over the last 2-3 years.

The chart above looks at U.S. listed companies' performance broken down by size and style. The chart starts in November 2021, when the U.S. Federal Reserve said they stuffed by, inflation wasn’t transitory and they were going to lift interest rates.

On the right-hand side of the chart, you can see the best performing to the worst performing parts of the share market.

The best performing group of companies unsurprisingly is the Magnificent Seven. They've been driving U.S. large caps higher and both the Magnificent Seven and S&P 500 have been hitting record highs (before their most recent pullback). That is where the momentum is, but there's also good momentum in U.S. mid caps.

The next level down is U.S. small caps followed by U.S. micro caps.

Simply put, performance has been driven by size.

So why are the larger ones breaking out and hitting record highs, while smaller companies aren’t?

The red line in the above chart tracks the median economists’ prediction of a recession in the U.S. in the next 12 months (as per Bloomberg).

In a normal year, the chances of a recession is about 15% (baseline) but as you can see from November 2021, it has steadily climbed up to around 65% before coming down as the soft landing narrative became more of a possibility. This coincides with indexes lifting.

However, U.S. small caps and micro caps have not been catching the same bid as their larger counterpart. Some surveys show that all-cap managers currently have the lowest level of exposure to small caps on record.

Whilst we have certainly felt the tide go out of small caps, we feel that relative valuations to large caps have become so extreme that it likely can’t get much worse.

The chart above compares the valuations (forward P/E) of the Russell 2000 (tracks U.S. small caps) and the Russell 1000 (tracks U.S. large caps).

You can see that U.S. small caps are trading about as cheap as they traded during much of the dotcom bubble in 2000/01.

When valuations got to these levels back then, it didn’t last long with U.S. small caps rallying strongly and valuations catching up. Over the next seven years after 2001, we saw circa 7% outperformance per annum in U.S. small caps versus large caps.

It's really hard to work out if there is going to be a recession in the U.S. But in my view the valuation disconnect between U.S. small caps and large caps is so big now and the direction of small caps can really only go one way versus their larger peers over the next few years.

The question is how long before the small caps really catch a bid and outperform U.S. large caps like they do in all rallies from the bottom. We don't know the answer to that, but what we do know that when it happens, it always happens very, very quickly.