The bull case for small caps as the second half kicks off

Published Thu, Jul 4 20248:31 AM EDT

The bull case for small company stocks is still intact for many investors as they head into the back half of 2024 after a lackluster six months. Small-capitalization stocks were widely expected to outperform this year — the group typically does well in a presidential election year — and it was thought would get a boost from reduced borrowing costs when the Federal Reserve started lowering interest rates. Instead, those hopes have been dashed. While the S & P 500 has surged to all-time highs this year on the back of a small subset of mega-cap technology stocks, climbing 15%, the small-cap Russell 2000 index has barely budged, eking out a less than 1% gain. The median market value of a stock in the Russell 2000 is a little less than $1 billion, versus about $31 billion for one in the S & P 500. .RUT YTD mountain Russell 2000 Small-cap companies posted their worst first half relative to large-cap stocks since Richard Nixon was president in 1973, according to Steven DeSanctis, small- and midcap strategist at Jefferies. Going back to 1926, it was the sixth worst half in history, he added. Still, believers say that there's time for small-caps to make up ground, as they did at the end of 2023. Not only is the environment still favorable for small company shares, but they sell for low valuations relative to large caps, suggesting there's an opportunity for investors to capture some upside. "Be cognizant of your allocation. Mainly due to the fact that, you know, who would have guessed in December, small cap outperformed large cap by 800 basis points. But that's what happened. 800 basis points in 20 trading sessions. That's huge," said Jefferies' DeSanctis. "You can give up a lot of relative performance pretty quickly." DeSanctis has a year-end target of 2,180 for the Russell 2000, representing roughly 7% upside from current levels. By contrast, the S & P 500 has already reached Jefferies' bull case of 5,400, the strategist noted. Elsewhere, the consensus price target for the S & P 500 at the end of the year among strategists surveyed by CNBC Pro is about where the index stands today. The right catalyst For investors, the bull case for small caps that prevailed when the year began, still holds. The asset class typically does better in an election year. U.S.-based companies are expected to benefit from secular tailwinds such as the reshoring of supply chains, and smallcaps can get a boost after the Fed starts to lower rate cuts, which could come as soon as September. More immediately, second-quarter earnings may prove a positive catalyst for small caps since expectations are so low, according to Jefferies' DeSanctis. According to consensus estimates from bottoms up analysts, small-caps are set to post a double-digit earnings decline of 12.4%, while the S & P 500 is expected to see 9% earnings growth. In recent years, small caps already have a history of beating expectations in earnings, the strategist noted, but what could additionally help the companies now are capital ratios and cash levels that are slightly higher relative to their history. "People were worried about small cap balance sheets," DeSanctis said. "I'm less worried." Valuation For many investors, it's hard to justify an allocation to small-caps when a handful of mega-cap stocks have so dominated the market rally. But small-cap proponents say that this is the time to trim some exposure to the Magnificent Seven , even if the long-term prospects for the group remain bright. The "easy money has been made in the AI space," said Brian Leonard, a portfolio manager of small- and mid-cap stocks at Keeley Teton Advisors. Market observers expect there could be a rotation into small-caps after historically low interest in the group. Small caps today account for less than 4% of the entire U.S. equity market, "so, like, no one's there" in terms of investor attention, DeSanctis said, adding that it would only take a "little bit of interest" for the group to start performing. As a whole, valuations are compelling, advocates say. On a trailing 12-month basis, the S & P 500 is trading at a multiple of 25 times earnings. The iShares Russell 2000 ETF (IWM) , which tracks the small-cap index, trades at just 14 times. To be sure, other investors are skeptical. While they expect that interest rate cuts could be a boon for the asset class, they also say that small caps — which tend to be more economically sensitive than larger companies — could get swamped in an economic slowdown. "I think at a minimum, we would need to kind of churn through a period of weakness here in the economy before maybe you could get a spark that sends small caps higher," said Ross Mayfield, investment strategy analyst at Baird. "I would be favoring large over small at this point." Ultimately, however, many investors say that a rotation into small caps is coming, even if it hasn't happened yet. "There's a lot of opportunity in mid- and small-cap stocks, a) from a valuation standpoint, and B) from an opportunity standpoint, especially being focused domestically, by and large, that could really set up investors well for years to come as the market rotates," Keeley Teton's Leonard said. "When that rotation happens is anybody's guess, but as we've seen through many market cycles, the market does rotate." DeSanctis almost put it down to the law of averages. "Something's got to go right for small cap at some point," he said. "At some point, it's going to have to start to outperform."