Whatever happened to that small-cap rally?

Okay, so maybe small-caps won’t get their day in the sun. At least not yet.

Despite all the year-end predictions that small-cap stocks would outperform in 2024, the Russell 2000 index has gained 1 percent while the S&P 500 is up 8 percent so far this year.

That relative underperformance has a lot of Wall Street analysts scratching their heads as to why small-caps have not finally taken the baton from the Magnificent 7 and the rest of the mega-caps.

Not Ellen Hazen, chief market strategist at F.L. Putnam Investment Management, however.

“If you look at history what you learn is that small caps only outperform when we're exiting a recession and that's because they're very cheap. They've been left for dead, and as we exit a recession, the economy accelerates,” said Hazen. “But that's not where we are right now. We never had that recession.”

In her view, small-cap stocks have higher debt and especially floating rate debt, so they are adversely exposed to the higher-for-longer interest rates regime. Furthermore, she says small-caps have only half the earnings growth of large cap stocks this year which will also hold them back.

In other words, rumors of life in small-cap stock world have been grossly exaggerated.  

“But when the time comes it's going to be big,” said Hazen.

Scott Bishop, managing director at Presidio Wealth Partners, has also stayed underweight small and mid-caps because their cost of capital is substantially higher, a problem that has grown even more acute with regional bank issues.  

“I have been waiting for the soft- or hard-landing recession to pivot more to small cap,” said Bishop. “At that time a few things typically happen, the Fed lowers rates and the small companies are more nimble to pivot into an post-recession expansion where you tend to get outperformance.”

In the meantime, Bishop believes the market and market commentators will continue to play up the Magnificent 7 and other mega-cap bellwethers.

But hey, says Bishop, it’s hard to blame them for getting all that attention.  

“The Magnificent 7 has been the place to be, as those are large companies that did well during the pandemic and have low costs of capital. They also tend to have good free cash flow and are market leaders in their respective sectors,” said Bishop.  

“Still, that outperformance won’t last forever, and I believe as we move through this market cycle, there will be more rotations into other sectors, and past AI which was a large part of this recent boom,” said Bishop.

Matt Liebman, CEO of Amplius Wealth Advisors, agrees that the call for the rotation into small-caps was premature. That said, he reminds clients that market timing is difficult and there is still a strong long-term case for small-caps, especially if - and when - interest rates come down.

“Large corporations with healthy balance sheets took advantage during the low interest rate era to lock in long-term borrowing costs at cheaper levels by accessing the bond market,” said Liebman. “Small companies often have to borrow for a shorter-term or on a floating rate basis. The move to a potential higher for longer interest rate environment is a head wind for small caps.”

Dan Pazar, executive vice president at Taiko, an OCIO for RIAs, says the call for small cap leadership went hand in hand with the market’s incorrect prediction for 6 Fed rate cuts.

“Small-caps as a percentage of revenue, pay a higher dollar amount in interest on their debt which is one reason, in addition to higher labor costs and generally higher inflation as to why they are trading at historical discounts relative to large caps,” said Pazar.  

For a broader improvement in small-cap performance, Pazar would want to see a combination of no more rate increases or rate cuts, inflation trending down towards 2 percent and economic growth. Until he gets those ingredients, he can’t argue with those seeking comfort in the Magnificent 7 and mega-caps.

“There is more comfort in the quality and transparency of earnings in larger names and the levers they can pull to manage their balance sheet and expenses,” said Pazar. “The risk is always the negative earnings surprise at those valuations when the market starts to change its focus.”

Meanwhile, Chuck Etzweiler, chief research officer at Nepsis, blames the indexing methodology of the Russell 2000 as the main culprit for the discrepancy between large and small cap stock returns.

“The index has less in Technology stocks at 17 percent versus the S&P 500 at 30 percent,” said Etzweiler. “Furthermore, the Russell 2000 while has greater representation in financial stocks versus the larger cap index with many of those being smaller, regional banks that have suffered in an inverted yield curve environment.”

Brian Glenn, chief investment officer at Premier Path Wealth Partners, also parses the indexes themselves to explain why small-caps are trailing, but from an earnings perspective.

“About 40 percent of the Russell 2000 is companies with negative earnings. The S&P 600, for example, which simply applies a positive earnings screen for initial inclusion, has outperformed the Russell 2000 by about a percent and a half over the past 20 years and the past 10,” said Glenn. “We think that’s telling and we lean into that fact, as well as other more specific fundamental factors in the space that might further curate attractive exposure within small-caps.”

Glenn adds that the relative value in small-caps will eventually be noticed by both investors and larger companies seeking to achieve growth targets.

“We maintain the view that smaller cap returns over the long-term will remain attractive,” said Glenn. “It’s an area ripe for buyout activity, especially given current valuations.”