If you are annoyed with large-cap stocks due to high market concentration and high valuations, allocating to small-cap stocks can provide you with some peace of mind. Aside from concentration and valuation considerations, there are several good the reason why that is a great time to take into consideration adding small-caps to your portfolio.
While the U.S. stock market hit all-time highs in June, market concentration in large-cap stocks also approached levels not seen for the reason that tech bubble. The top 10% of names account for about 66% of the Russell 1000 Index’s total market capitalization as of May 31. Stock market valuations for the Russell 1000 Index, which represents the 1,000 largest U.S. firms by market capitalization, also appear elevated. The index’s price-to-earnings (P/E) ratio of 25.6 in May is within the 92nd percentile for the ratio since its inception.
Source: FactSet, Bloomberg, NTAM Global Asset Allocation Quantitative Research. Data from 1/1980 to five/2024. Equity concentration is the proportion of total market capitalization of the ten% largest firms within the Russell 1000 Index.
More attractive fundamentals
After many years of technological advances, technology sectors reminiscent of information technology and communications services now account for greater than 38% of the whole weight of the Russell 1000 Index. The valuations of the mega-cap firms in these sectors have been high as a result of high growth expectations. In contrast, the distribution of sector weights and P/E ratios of the constituents of the Russell 2000 Index (2,000 small-cap firms) is more moderate and normalized, as shown in Figure 2.
Source: FactSet, Bloomberg, NTAM Global Asset Allocation Quantitative Research. As of May 31, 2024.
Compared to their very own history, small-cap stocks trade at a big discount to large-cap stocks. Figure 3 shows the forward P/E ratios of the Russell 2000 Index versus the Russell 1000 Index since 1990. As of May 31, the forward P/E ratio of small caps versus large caps was 73%, meaning that small caps currently trade at a 27% discount to large cap stocks. Such a low discount ranks 18thth percentile of the last 35 years.
Source: FactSet, Bloomberg, NTAM Global Asset Allocation Quantitative Research. Data from 3/1990 to five/2024. Exclude stocks with negative returns.
The valuation ratios between small caps and enormous caps have predictive power for his or her future relative performance. In Figure 4, we now have created a scatter plot between the P/E ratios and the 10-year return spread of small caps and enormous caps. The trend line slope is -0.11. The negative slope or beta coefficient indicates that cheaper relative valuations can lead to raised performance of small caps. Relative valuation explains 60% of the whole variance within the 10-year return spread. Given the present historically low valuations, we expect small caps to outperform large caps over the following 10 years.
Source: FactSet, Bloomberg, NTAM Global Asset Allocation Quantitative Research. Data from 3/1990 to five/2024. Forward PE excludes stocks with negative returns.
Small caps perform higher in economic recovery
Small-cap firms are younger firms with less established businesses than large-cap firms. Small-cap stocks are more sensitive to economic conditions and due to this fact more correlated with business cycles. When the economy begins to get well and grow, small-cap stocks rebound essentially the most due to their more attractive valuations. Figures 5a and 5b show the typical return of small caps versus large caps across different business cycles. Small caps outperformed large caps by a mean of 66 basis points (bps) and 493 basis points during recovery and expansion phases, respectively.
Source (5a and 5b): FactSet, Bloomberg, NTAM Global Asset Allocation Quantitative Research. Data from 1/1984 to 4/2024. The performances in Figure 5b are annualized average monthly returns of small (Russell 2K) and enormous (Russell 1K).
Our macroeconomic regime model suggests that we’re currently within the recovery phase because the month-on-month change in leading indicators has remained negative but is trending upward. Small caps will outperform large caps because the economy moves toward full recovery and beyond.
Interest rates can provide small caps a tailwind
Small businesses should not have the identical access to debt capital as their larger brothers. They also rely more heavily on variable-rate and short-term loans to finance their operations. When the Federal Reserve (Fed) tightened monetary policy by raising rates of interest, small businesses faced significantly higher costs of capital, which might negatively impact their profitability. However, when the Fed begins to loosen monetary policy by cutting rates of interest, small businesses will profit more from improved credit conditions than large businesses.
Figure 6 shows the rate of interest sensitivities of the yield spread between small caps and enormous caps to changes within the fed funds rate. In the scatter plot, the y-axis is the one-year forward yield spread between the Russell 2000 and the Russell 1000. The x-axis shows the quarterly change in effective fed funds rates. Negative regression betas show that past rate cuts have led to raised future performance of small caps. The forward-based relationship can also be statistically significant with a t-value of -3.1. The evaluation provides empirical evidence that expected Fed rate cuts are prone to provide a tailwind for small caps.
Source: Bloomberg, NTAM Global Asset Allocation Quantitative Research. Quarterly data from 1/1984 to five/2024.
Small-cap firms may benefit from reshoring
Source: FactSet, Bloomberg, NTAM Global Asset Allocation Quantitative Research. As of: June 17, 2024.
Key finding
Investors have gotten increasingly concerned about large-cap stocks as a result of high market concentration and high valuation. At the identical time, small-cap stocks seem like underbought despite their attractive fundamentals.
Current economic conditions are encouraging a recovery in small-cap stocks, and the re-shoring should profit smaller US firms in the long run. All of those aspects together make it a great idea to take a position a few of your assets in small-cap stocks.
