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After years of underperformance, small-cap stocks, as measured by the Russell 2000, have recently attracted renewed attention from investors. They have outperformed large-cap stocks, as measured by the S&P 500, by over 4% from July 11 through July 19.[1]
This shift was sparked by lighter-than-expected US inflation numbers released on Thursday, July 11. Small-cap stocks surged 3.6% that day, marking their best one-day performance since October 2022.[2]
Is it time for the unloved to become loved again? Before we answer, let's explore what small caps are, how they differ from their larger counterparts, their past performance, and the reasons for their recent resurgence.
When examining US small caps versus US large caps, there are significant differences in terms of market capitalization, business characteristics, and investment prospects.
- Market capitalization:
- Small-cap stocks: Typically range from $300 million to $2 billion.
- Large-cap stocks: Usually exceed $10 billion.
- Risk and volatility:
- Small-cap stocks: Tend to be more volatile and carry higher risk due to less market stability and lower liquidity.
- Large-cap stocks: Exhibit lower volatility due to their relative stability and established market presence.
- Financial stability:
- Small-cap stocks: May have less financial stability and fewer resources to weather economic downturns.
- Large-cap stocks: Usually have greater resources and generate positive cash flow, making them potentially more resilient in economic challenges.[3]
In recent years, small-cap stock performance has lagged their larger counterparts, leading some to dub this period the "lost decade" for small caps. While large-cap stocks managed to navigate through high inflation and rising interest rates, smaller companies struggled under these conditions.
It is also helpful to examine the sector differences in each index to understand why large-cap and small-cap stock performance has varied. The S&P 500's superior performance compared to the Russell 2000 over the last years can largely be attributed to the stellar returns of the ” Magnificent Seven” – which includes Nvidia, Meta Platforms, Amazon, Apple, Microsoft, Alphabet and Tesla. Further, the technology sector, led by Apple, Microsoft, and Nvidia, is now 32% of the S&P 500 index. As seen in the chart below, technology is a much smaller sector in the Russell 2000, accounting for only 13% with zero exposure to the “Magnificent Seven.” [4]
As can be seen in the chart below, small-cap stocks (orange line) have increased dramatically in just the past few weeks.[5]
The recent outperformance of small-cap stocks compared to their larger counterparts can be partly attributed to positive inflation reports, which investors have taken to mean:
- The Fed may soon cut interest rates
- Small-cap stocks are more dependent on borrowing and therefore have higher risk from lending rates
- Therefore, lower interest rates would benefit small-cap stocks to a greater degree than large caps[6]
As reflected in the chart below, small-cap stocks are outperforming recently but still underperforming large-cap stocks on a year to date and over a 1-year basis.[7]
The recent rise of small-cap stocks has largely been investor sentiment driven based on expected interest rate trends and political forces over business fundamentals. For this trend to sustain, our opinion is that smaller companies will be reliant upon resilient economic growth to continue as interest rates fall. Further, small caps will be reliant upon different sector dynamics, especially performance from financials, industrials, and healthcare, as opposed to the heavily weighted technology sector in the S&P 500. At Gradient Investments, we have some exposure to small-cap stocks in our Endowment Series model as well as growth-oriented small-cap stocks in the G33. As we continue to examine business fundamentals and the economic cycle, we will communicate any change to our allocations in small-cap stocks.
[1] FactSet as of 7/19/2024
[2] https://www.ft.com/content/6e731ef2-8979-46f8-a4ac-742042d2bab7
[3] https://www.bankrate.com/investing/large-cap-vs-small-cap-stocks/#:~:text=Large%2Dcaps%3A%20Stable%20returns%20with,steady%20returns%20by%20large%2Dcaps.
[4] FactSet as of 7/19/2024
[7] FactSet 7/19/2024