The past year will go down in the history books as a dud in terms of stock market returns. You’re among the lucky few if you were able to generate positive returns given that the broad market is down 2% year-to-date. But I have two pieces of good news.
First, that lackluster performance is in the rearview mirror. Good riddance.
And second, the future looks a heck of a lot brighter—at least for one particular group of stocks. I think there is 15% upside potential in small-cap stocks over the next year. And that potential has me making a few last minute holiday purchases.
Why am I so bullish on small caps when the market hasn’t done anything for a year? I’ll give you five reasons.
Reason #1: Rising Interest Rates Are Good for Small Caps
For the first time in 9.5 years (since June 2006), the Fed raised interest rates. And it will likely do so at least a couple more times in 2016 given that interest rates are still historically low. Many people think that rising interest rates are bad for small-cap stocks. Guess what? Results over the last four decades show that line of thinking is wrong. Rising rates have actually been good for small caps, not only in absolute turns (generating higher returns than in falling rate environments) but also in relative terms (generating higher returns than large caps).
I’ve studied data from Fidelity dating back to 1979, and it all points toward a number of positives for small caps that arise during a hiking cycle. Without getting into all the specifics, the bottom line is that small caps have enjoyed an average 12-month gain of 13.94% when long-term rates rise by 0.96%. And when short-term rates rise by 1.17%, small caps average a 12-month return of 15.16%. Given that the Fed’s dot-plot signals four more quarter-point increases in 2016, it looks like the pace of projected increases during this cycle should support another period of strong performance for small caps.
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Reason #2: History Suggests Small Caps Have Little Near-Term Downside Right Now
There is a downside to rate increases. Stocks, including small caps, tend to go down before they go up after the first rate hike. Over the last three rate hikes (in 1994, 1999 and 2004), the average decline in small caps was 13%. The annual declines are detailed in the chart below.
But there’s a catch that’s particularly relevant this time around. Those declines were measured from peak to trough. In 1994 and 1999, the peak came after the first rate hike. In 2004, it came before. That was good, because it meant the trough came sooner too—just 30 days after the first rate hike (versus 99 days after in 1994, and 76 days after in 1999).
This time around, small caps peaked well before the first rate hike. This is very good news for small-cap investors. The Russell 2000 peaked at 1,296 on June 23, 2015. That was 128 trading days ago. Since then, it has fallen 13.2%.
That performance (or lack thereof) implies that the typical small-cap decline, which averaged 13% over the last three rate hike cycles, has already occurred! In other words, history suggests the bottom is in. It’s never wise to call it, but this time I’m doing just that. I’ll be surprised if small caps fall more than a couple of percentage points from where they are right now.
Reason #3: Small Caps Outperform During Economic Expansions
The Fed wouldn’t have raised interest rates if it didn’t see GDP growth on the horizon. It currently forecasts GDP growth of 2.1% in 2015 and 2.4% in 2016. That’s part of why it felt justified in raising interest rates, which tend to go up when the U.S. economy is healthy and economic growth is accelerating.
U.S. GDP expansion also provides an excellent backdrop for small-caps stocks given that around 80% of small-cap sales come from within the U.S. Expansion leads to revenue and earnings growth, which are the main drivers of growth stock appreciation. That’s not opinion, it’s fact. Data from Fidelity shows that the average 12-month rise for small caps during economic expansions is 20.97%, versus an average 12-month return of 4.83% during economic contractions.
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Reason #4: Small Caps Have Underperformed for Two Consecutive Years
The historical relative performance of small caps also suggests a good year in 2016. It’s been two years now that small caps have underperformed large caps. Given that small caps do better than large caps over the long-term, it’s time for them to get moving again. Check out the annual returns for the S&P 600 Small Cap Index versus the S&P 500 Large Cap Index in the chart below and you’ll see what I mean.
Reason #5: Small Caps Valuations Have Room to Rise
Small-cap valuations have room to move higher right now. Some analysts will say that the S&P 600 Small Cap Index’s forward P/E of 17.1 is high, but since the beginning of 2013, it’s traded in a range between 16 and 20, so there’s room to the upside before these stocks are truly expensive.
Also, the current P/E is being pulled higher by a ridiculously high forward P/E of 80 from the small-cap energy sector, which has seen earnings plummet with oil below $40. While small-cap consumer staples, utilities and health care stocks trade at a premium to historical norms, small-cap technology and consumer discretionary stocks do not.
The Bottom Line
History suggests we’re looking at a 12-month return of around 15% for small caps. That seems entirely reasonable to me. After all, just to get back to the prior 52-week high, we now need a 15% rally in the Russell 2000.
Investors have a couple of choices on how to play it. If you like to keep things simple and go for market performance, you can purchase small cap ETFs. My favorite is the iShares Core S&P Small-Cap ETF (IJR).
Your guide to small-cap investing,
Tyler Laundon
Chief Analyst, Cabot Small-Cap Confidential 2.0
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