Is now the time to buy small-caps?

Big tech and work from home under pressure

Valuations for big tech companies have skyrocketed, as the work from home COVID-19 induced economy has flourished. Companies like Zoom Video and Peloton are up 585% and 260% respectively year to date. That doesn’t necessarily mean that these companies don’t have staying power—we believe they do—however, the potential for these companies to continue to grow at these rates and meet Wall Street’s lofty earnings expectations are under pressure.

We believe small cap equities will outperform large cap equities over the medium term (12+ months) as the economy opens back up and a broader economic recovery warrants a tactical allocation in portfolios. An area that we favor in this market environment and believe poses opportunities are small cap equities for a number of reasons.

Early cycle to mid-cycle environment favors small caps

Since 1962, equities have delivered their highest absolute performance during the early cycle, with an average total return of more than 20% per year during this phase, which has lasted roughly one year on average. Sectors that have historically outperformed in a low interest rate environment and during a broad economic recovery are healthcare, consumer discretionary, industrials, technology, and real estate.

Consumer discretionary stocks have outperformed the broader market in every early cycle since 1962.

Early-cycle laggards include communication services and utilities, which generally see fairly consistent demand. But while communication services have historically underperformed, its evolving mix of industries raises questions about whether it will do so in the future. Energy stocks have also lagged during the early phase, when inflationary pressures and energy prices tend to be lower. The COVID-19 induced demand pressure on energy also indicates a period of underperformance.

Small cap equities have outperformed large caps in 9 of the last 10 recessions

Small caps generally experience steeper declines early in a recession due to a flight to safety that naturally occurs, resulting in oversold conditions and undervalued small and mid-cap equities. As a result, these companies tend to outperform large-cap companies as the broader economy emerges from recession.

Difference in total return of small cap equities vs large cap equities

Smaller companies tend to get a performance boost when mergers and acquisitions activities increase, which is common toward the end of a recession when valuations become more attractive and larger companies look for ways to grow their businesses.

Economic activity drastically increases

We believe the latest recession is over and the new economic expansion has begun. Although we are not completely out of the woods when it comes to emerging from the COVID-19 induced recession, economic data has vastly improved and signals that the worst might be behind us.

The US economy grew at a record pace in the third quarter as GDP increased 7.4% compared to last quarter and increased 33.1% compared to Q3 2019.

The government will need to limit shutting down businesses wherever possible and increase fiscal stimulus by year end and throughout 2021 in order to avoid a double dip recession. 

The Fed has already pledged to do everything in their power by keeping rates at zero until at least 2023, but we need the federal government to step in to provide assistance to struggling industries like restaurants and travel to limit higher long term unemployment.

Streak of underperformance might be over

Small caps underperformed large caps by 33% from June 2018 through the March 2020 lows, as measured by the Russell 2000 Index; however, historically, small caps have outperformed coming off major bear market bottoms and recessions. Small caps are beginning to signal that this streak of underperformance might be ending.

From the March 23rd low to October 15th, the Russell 2000 has outperformed the S&P 500 Index by more than 13%, and the ratio between the two indexes has moved back above the 200-day moving average for the first time in more than two years. We do not view this as a timing signal to go significantly overweight small caps, but believe it demonstrates that the trend has shifted to a more balanced stance between small and large caps and are adding an allocation to small caps in client portfolios.

As of October 12, 2020, nearly 60% of the individual stocks in the Russell 2000 were trading above their respective 200-day moving averages, the most we have seen since the stock market bottomed in March. This helps to show that improved performance is not limited to a particular style or sector of the index, but that participation is healthy and trending upward.

Small cap earnings could be poised for a strong 2021

Small cap earnings are expected to rebound sharply in 2021—potentially by 180% based on the latest FactSet estimates—to more than 10% above 2019 levels. Greater economic sensitivity provided by small cap equities compared with large cap equities may be helpful when economic growth expectations go from bad to less bad, and eventually to good.

Furthermore, small cap earnings momentum has been quite positive. Since June 30, 2020, small cap earnings estimates for 2020 have been revised about 12 percentage points higher, more than the 4–5 percentage points for large caps. For 2021, earnings growth for small caps has been revised more than 30 percentage points higher, while large cap estimates have increased by only 2 points.

Conclusion

While we believe that small cap equities are in a position to outperform large cap equities, this view could take up to six months to play out. This should be viewed as a medium to long term investment and be held for 12+ months in order to allow for certain headwinds to dissipate and for the broader economic recovery thesis to come into full effect as COVID-19 becomes less of a threat. We are still recommending overweight positions in US technology and the NASDAQ 100 index; however, we believe that gains from high flying tech names can be reallocated to small cap equities for a tactical allocation of no more than 10% of a moderately aggressive portfolio.

We acknowledge that the greater financial strength enjoyed by large caps has helped that asset class in this uncertain environment, but we have seen broad based improvement in the underlying conditions that may be supportive of small caps. While risks to the economic recovery continue to loom, if the economic expansion becomes more durable, we would recommend increasing allocations of small cap equities versus overweight. We believe the best strategy is to build a position in small caps starting in Q4 2020 and continue to do so throughout 2021 as the economy further comes out of recession. 

Disclosures:

This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial advisor/financial consultant before making any investment decisions. The opinions expressed are those of the author as of October 30, 2020, are based on current market conditions and are subject to change without notice. Investors must take into account their particular time horizons and risk tolerance. Before investing, investors should carefully read the prospectus and/or summary prospectus and carefully consider the investment objectives, risks, charges and expenses and consider their personal investment goals/objectives, time horizon, and risk tolerance. Past performance is not indicative of future results. The information contained in this report has been gathered from sources we believe to be reliable, but we do not guarantee the accuracy or completeness of such information, and we assume no liability for damages resulting from or arising out of the use of such information.