AFSM - Small-Caps Are Due For A Comeback In 2024

2023-12-08 01:12:15 ET

Summary

• Small-cap stocks have performed poorly this year, with the S&P 600 only gaining just over 4% compared to the S&P 500's 20% YTD gain.
• Small-cap stocks have been impacted by declining earnings, with S&P 600 earnings expected to fall by 14% this year.
• Rising interest rates have been a major factor in the poor performance of small-cap stocks, but we are nearing an inflection point that is likely to drive small-cap stocks higher.

Being a small-cap stock investor has been hard this year. Well, to be more precise, it has been hard for a few years now. The soaring comeback of stock markets this year has been characterized by the stellar gains of some major tech companies. If you look deeper into the performance of stock markets this year, you will find that a few big names have driven the S&P 500 higher.

At the end of the third quarter, the S&P 500 Index was up over 12%. We need to remember that the S&P 500 is a market cap-weighted index, meaning that bigger companies will take up a larger percentage of the index. If we rearrange the S&P 500 index as an equal-weighted index, meaning that all constituents of the index will be assigned the same weight regardless of their size, the index would have only gained 0.1% through Q3. That is an alarming data point that suggests only the largest few companies are driving the bulk of the gains for the index. 'Magnificent 7' stocks have delivered stellar returns this year, as illustrated below, accounting for almost all the gains the index has posted in 2023.

While the S&P 500 has been driven higher - almost 20% YTD - aided by a few names, the S&P 600, which is home to small-cap stocks (the average constituent has a market capitalization of $2 billion), has only gained just over 4% this year. It is an understatement to say that small-cap stocks have performed poorly this year.

Before we jump to any conclusions, let's acknowledge that small companies have had a forgettable year from a financial performance perspective as well. According to FactSet, S&P 600 earnings will fall by a staggering 14% this year on the back of a 1% YoY decline in revenue. In contrast, the S&P 500 is expected to post a modest 1% YoY increase in earnings this year. Going by earnings growth expectations, it is no wonder that small-cap stocks have performed poorly this year as the market is supposed to follow earnings.

If you want to know why earnings for S&P 600 companies have declined this year, you don't need to look further than rising interest rates. Unlike their larger counterparts, small companies often struggle to deal with rising rates as they fail to manage costs effectively to negate the impact of higher interest rates. Also, small companies tend to carry more floating-rate debt than large companies, which ends up hurting profit margins when rates rise.

Looking ahead, rates are more likely to be cut than raised. For now, the Fed is very unlikely to cut rates prematurely as economists need to monitor the full effect of recent rate hikes before making a U-turn. A few weeks ago, Fed Chair Jerome Powell reinforced the Fed's cautious approach toward rate hikes. This is a good sign for small caps.

In the coming months, I believe rate hike fears will subside, but it would be naive to expect policymakers to turn dovish. That would take some time - probably until mid-2024 before we see a monetary policy framework more conducive to growth. However, as investors, we cannot wait until this has happened to make our moves.

Assuming markets will remain true to their forward-looking nature, I expect the sentiment toward small-cap stocks to improve meaningfully in the coming months ahead of a reversal in monetary policy decisions.

The question is, are small caps more attractive from a valuation perspective as well? Knowing that large caps are driving short-term returns higher for the S&P 500, as investors, it is natural to look for an incentive to invest in anything other than large companies. The incentive comes in the form of valuation. As illustrated below, the S&P 500 is substantially more expensively valued compared to the small-cap-heavy S&P 600.

At a forward P/E of just 13, the S&P 600 is valued very attractively today.

In conclusion, I expect the changing stance of the Federal Reserve toward rate hikes to benefit small-cap stocks more than their large-cap peers in 2024. This is a good enough reason to gain exposure to select small-cap stocks.

Stay tuned for the next article!

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