US small-cap stocks are lagging significantly behind their larger counterparts, marking the worst performance gap in over two decades. This divergence underscores a dramatic shift in investor sentiment. Traditionally known for outsized gains (along with greater volatility), small-caps seem unable to keep pace with tech giants benefitting from the AI frenzy.
Since early 2020, the Russell 2000 has climbed a modest 24%, while the S&P 500 has surged over 60%. This yawning gap has become particularly pronounced in recent years. Small-caps, with typically weaker balance sheets and limited pricing power, have been hard hit by inflationary pressures and soaring interest rates.
According to one of our analysts, small-cap investing has lost its allure since 2016-2017. The absence of “animal spirits” within the market, along with the dwindling of M&A deals and IPO activity, has dimmed the sector’s appeal.
Meanwhile, the S&P 500’s steady ascent since late 2023 has been largely fueled by tech behemoths like Nvidia and Meta, riding the wave of AI excitement. In contrast, the small-cap rally that gained momentum late last year has fizzled out, leaving behind underperforming stocks from diverse sectors like utilities and telecoms.
This underperformance marks a stark departure from the early 2000s. During that period, when interest rates hovered near zero following the financial crisis, small-caps routinely outshone large-caps. One of our analysts attributes this historical trend to a mix of market inefficiencies and the explosive growth potential of emerging companies.
Small-cap success stories, when successful, have historically boasted earnings and revenue far exceeding initial projections – leading to remarkable gains. Examples like Shake Shack and Wingstop underscore the allure of such investments.
However, while recent market trends suggest a broadening rally beyond giant tech stocks, a hawkish Federal Reserve could keep the pressure on small-caps. If rates remain elevated for an extended period, companies within the Russell 2000 face outsized challenges due to their reliance on short-term or floating rate debt.
Earnings data paints a sobering picture. Fourth-quarter results for Russell 2000 companies indicate a 17.6% year-on-year decline, while the “Magnificent Seven” tech stocks have largely buoyed the S&P 500.
Yet, a silver lining exists for small-caps. If a recession is averted, and interest rates begin a decline, the sector’s profit picture becomes rosier. Analysts generally anticipate 14% earnings growth for Russell 2000 companies this year.
Moreover, improving financial conditions, coupled with greater access to capital, could provide tailwinds. One of our analysts highlights the significant easing of high-yield market conditions and an uptick in equity issuance as positive signals for the small-cap space.
The sector’s current undervaluation could also present an intriguing long-term opportunity. Historically, small-caps have traded at similar multiples to the S&P 500. However, the recent large-cap surge has created a near-record discount within small-cap valuations. History suggests these discounts offer attractive entry points, as evidenced by the outperformance of small-caps during the 2000s following a similar period of undervaluation.
