Six weeks ago I wrote a piece talking about how small caps have lagged the market but are pretty darn attractive looking forward.
Fast forward a month and a half and small-cap stocks have just had an historic rally.
Have investors finally woken up to the potential? And can small-cap stocks continue to move higher?
A Historic Small-Cap Stock Rally
Two weeks ago, on Thursday, July 11, CPI data for June came in lower than expected, supporting the disinflation trend and significantly increasing the odds of a September rate cut (current odds are at 89%).
That kicked off a rotational rally that saw Mag-7 stocks lose momentum and small and mid-cap stocks, which have been held back by high interest rates, take off.
Over the next five sessions, small caps posted their best five-day streak since April 2020.
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There was a bit of a wobble in the rally late last week, but small caps have traded higher again early this week. There’s no doubt that this was a powerful move by the little guys.
Bank of America’s latest Flow Show report showed that small caps attracted $9.9 billion last week (ending 7/17), their second-largest inflow ever. Total U.S. stock inflow posted its fourth-largest week.
The CPI data was a major kick in the butt for small caps. But the so-called “Trump Trade” (hopes for lower regulation, with an outsized benefit to smaller companies), was also a factor.
The Current Status of Small-Cap Stocks
From a performance perspective, last week’s small-cap stock rally certainly helped. But the asset class still trails the broad market by around 10% year to date (YTD).
The biggest area of small-cap underperformance is tech. It’s tough to compete with the Mag-7. Other areas like utilities and consumer staples have also lagged by a wide margin.
But last week’s rally put small-cap stocks front and center for a lot of investors that haven’t paid them much mind for well over a year.
I think that profile boost is likely to drive a wave of interest and additional buying as investors look for fresh opportunities in a market that’s been dominated by a relatively narrow group of companies.
And aside from improving sentiment, there are plenty of data points suggesting small caps have more to run.
The Case for More Upside
Keep in mind that while small caps are trailing by about 10% this year their underperformance has gone on a lot longer.
Since the beginning of 2023, small caps are only up 23%. That’s a far cry from the 48% return of the S&P 500 and 77% return of the Nasdaq.
In other words, small caps have a lot of catching up to do. And that move could last for a while, especially if big investors need to increase their allocation.
Barclays reported mid-week last week that Commodity Trading Advisor (CTA) positioning is still neutral on small caps and overweight S&P 500 and Nasdaq.
The implication is that there is still ample room for small-cap stock buying by big investors to get anywhere close to equal weight.
Turning back to BofA’s Flow Show, the report points out that small caps have seen just $37 billion of inflows over the past four years versus $789 billion into large caps.
Large caps have taken in more than 20 times as much as small caps since mid-2020! That’s just more data showing how small caps have been kicked to the curb.
Last but definitely not least, small caps trade with a very attractive valuation.
They have a forward PE of just 14.9. That’s at the low end of the “normal” market range over the last 25 years. In contrast, large caps have a forward PE of 21.
That small-cap discount could exist for a while, especially if interest rates come down (as is expected).
That’s because there’s a relatively high level of variable rate debt in the asset class. Lower rates should translate to lower financing costs, which could boost EPS. Higher EPS would, all other factors being equal, keep a lid on the PE because EPS (the denominator) would go up.
That virtuous cycle of improving earnings in an asset class that already has a relatively low PE can help drive an extended rally in share prices.
In short, I think it’s a good time to be allocating capital to small caps. The foundation has been laid, now we just need a few things to fall into place for small caps to shine once again.
Where to Find the Best Small Cap Stocks
By far the easiest way to get small-cap exposure is to buy an index ETF like the iShares Core S&P 600 Small Cap ETF (IJR).
You can turn up the dial a little if you want by buying a more growth-oriented fund, like the Vanguard Small Cap Growth ETF (VBK).
Or, if you’re interested in individual names with significant potential to outperform you can grab a subscription to my small-cap advisory service, Cabot Small-Cap Confidential.
Previous winners include names like Q2 Holdings (QTWO) and AppFolio (APPF), which we got into before anybody knew their names.
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