Can Small Caps Catch Up?

August 2, 2024

By Ellen Hazen, CFA®, Chief Market Strategist

July Takeaways:

  • Small-capitalization US equities sharply outperformed. During the month of July, the S&P SmallCap 600 Index appreciated 10.8%, while the S&P 500 Index appreciated only 1.2%. Year-to-date, the larger company index is still well ahead of the small-cap index, at +16.7% vs +10.0%, but the 6.7 percentage point difference is much lower than it was at the end of June, when the difference was a full 16 percentage points
  • Q2 2024 corporate earnings +11% Y/Y. With about three-fourths of S&P 500 companies having reported earnings through the end of July, we have a decent window into how companies have grown in Q2 2024. Thus far, revenue growth has averaged 5%, while earnings growth has averaged 11%. This bodes fairly well for the second half of 2024, in which analysts estimate that S&P 500 earnings growth will average 6% (Q3) and 12% (Q4). If achieved, 2024 earnings growth will be 9%
  • Inflation continued to slow. The Consumer Price Index for the month of June was negative 0.1% month-over-month, indicating that prices declined a bit. This was below expectations of positive 0.1% and gives Federal Reserve officials more reason to decrease interest rates
  • New jobs mixed. While the initial report for June jobs was better than expected, new jobs created in July were weaker, and the June estimate was revised lower. The most recent July reading of 117,000 jobs suggests a cooling economy, compared to the year-to-date average of 200,000 per month
  • Wage growth decelerated. The Employment Cost Index for the second quarter was +4.1% Y/Y, down from 4.2% Y/Y in the first quarter of the year
  • Fed kept short-term rates steady but may cut in September. On July 31, the Federal Reserve kept its overnight interest rate steady at a target range of 5.25-5.50%. The market is currently pricing in a 0.25% to 0.50% cut at the September meeting. The Fed’s statement noted that risks of inflation vs. unemployment are more balanced now, suggesting that easier monetary policy may be coming in the near future
  • Global central bank moves. The Bank of Canada and the Bank of England both joined the ECB as major central banks cutting rates in 2024. Most other major central banks have kept rates unchanged this year. By contrast, the Bank of Japan raised its rate from 0.10% to 0.25% in a surprise move in late July. It also announced a tapering of its bond buying program. Official commentary predicting higher inflation may indicate further rate increases are likely. This caused the Japanese Yen to strengthen, which has hurt Japanese equities in recent days and may slow Japanese export growth
  • Strong bond performance driven by lower rates and tighter spreads turned year-to-date returns positive. The Bloomberg Aggregate Bond Index appreciated by 2.4% in July, bringing year-to-date performance to 1.7%. Credit spreads tightened during the month as bondholders became more optimistic about an economic soft landing
  • US presidential election developments. Former president Trump chose Ohio Senator J.D. Vance as his running mate, while current president Biden dropped out of the race and endorsed current Vice President Kamala Harris. We believe both parties’ publicized policies may spur inflation

What We Are Watching In August:

  • More earnings. Most of the remaining 25% of S&P 500 companies will report second quarter earnings in August
  • Inflation – will it continue to moderate? The Consumer Price Index will be reported in mid-August. If it continues to soften from the June 3.0% level, the market’s hopes for a 0.50% rate cut may be bolstered
  • Jackson Hole – watch for signaling on September rate cut. The Fed does not meet again until September. However, Chairman Powell and others will speak at the annual Jackson Hole Conference, hosted by the Kansas City Fed. Will officials discuss the possibility of a 0.50% decrease in September?

 

We believe the small cap index outperformance observed in July is likely to be short-lived. 

Small company performance has been the dominant story for the past several weeks, as the S&P SmallCap 600 Index (“small cap index”) sharply outperformed the S&P 500 Index (“large cap index”) during the month of July. Over the past 2 years, there have been 4 months in which the small capitalization index outperformed the large capitalization index by more than two percentage points. In each case, the performance reversed over the subsequent months. The question becomes, will this time be different? Will small cap index outperformance continue throughout the rest of 2024?

Let’s examine some market dynamics, including valuation, earnings growth, earnings revisions, breadth, and economic sensitivity.

(+) The small cap index starting valuation was low relative to history

Over the past 20 years, the small cap index has traded at a median 2 multiple points higher than the large cap index, reflecting investors’ perception that smaller companies have higher potential long-term growth. Over the past 3 years, however, the small cap index has traded lower than the large cap index by an average of 5 multiple points and was over 5 points cheaper at the start of July. Thus, there has been a persistent valuation argument for holding small cap stocks – all that was needed was a catalyst to start to narrow that valuation gap.

(-) Revenue growth has been lower in the small cap index

Historically, smaller companies have grown faster than larger companies. The small cap index earnings per share growth averaged 15% during the years 2010-2020 while the large cap index earnings per share growth averaged only 8%. However, since 2020, small cap index earnings growth has been in line with the large cap index earnings growth, while revenue growth has been lower.

(-) Small cap earnings revisions have been negative for three years

Small cap index earnings estimates have been consistently declining for the past 2 years, while large cap index earnings estimates have been stable. This is one reason we have been reluctant to increase exposure to smaller companies. We believe it will be difficult for the small cap index to continue to outperform unless this trend reverses.

(+) The recent small cap index advance was supported by good breadth

One technical indicator we analyze to help inform our opinion on whether the recent strength in the small cap index is sustainable is whether the majority of individual stocks within the index were strong, or whether the rally was led by a handful of stocks. Breadth was indeed supportive, with an increase in the percentage of members of the small cap index above their 200-day moving averages from 50% to over 70%. All else equal, this is a positive sign.

(-) Small cap stocks are economically sensitive

Finally, small cap stocks generally underperform in a weakening economy, and outperform when the economy is reaccelerating after it exits a recession. July’s small cap index outperformance seemingly reflects an assumption that the economy will successfully achieve a “soft landing”; in other words, the economy is about to reaccelerate. Should this scenario fail to materialize, small cap index outperformance could reverse, perhaps sharply. This could occur if a broad range of economic indicators start to show a weaker economy or even an impending recession.

Investing is rarely black and white – there are generally several arguments both for and against a given position. In our view, given a slowing but not recessionary economy, we believe that the small cap stock rally observed in July is unlikely to sustain in the coming months, while the sharp move observed in July can be primarily attributed to the quite low starting valuation. Though inexpensive, small cap index stocks’ lack of earnings growth is problematic. Until small cap index earnings growth picks up, these stocks are unlikely to continue their current runup. We maintain a modest allocation to small cap companies for diversification purposes and will seek to increase this if conditions warrant.

Disclosures

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