Stock market trends last longer than anyone expects.
That was the oft-repeated adage of my former boss, Cabot legend Tim Lutts. And he was right. For all the tsk-tsking about the current bull market being long in the tooth, it’s actually tied for the shortest bull market (21 months) in history at the moment, according to data from Ryan Detrick of Carson Research Group. The average bull market lasts 61 months – nearly three times the length of the current one!
The same is true of bear markets, of course. The average bear market lasts 289 days, or nine and a half months. And that was almost exactly the length of the 2022 bear market, which began at the end of 2021 and lasted until mid-October of 2022 (although it dragged on even longer than that for growth stocks).
Then there’s the simple trend of “underperformance.” We’ve seen sustained underperformance in value stocks, which have underperformed growth stocks for more than a decade now. Chinese stocks have never fully recovered since Covid. And then there are small-cap stocks.
Historically, small-cap stocks outperform their large-cap brethren – in three out of every five years, according to our small-cap expert, Tyler Laundon. But not in the last five years. Since July 2019, the Russell 2000 (which tracks small caps) has trailed the S&P 500 by almost a 2-to-1 deficit, up 46% vs. an 89% gain in the large-cap index.
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Now, small caps would never be confused with value stocks, at least not collectively. Their very nature – young, up-and-coming companies many of which are not yet profitable – makes them more speculative than easily measurable. And yet, as of June 30, the Russell’s price-to-earnings ratio excluding companies with negative earnings (big caveat, to be sure) was 16.9 – its cheapest valuation since the Great Recession in 2008.
Given that backdrop, surely the tide had to turn eventually … right?
Small-Cap Rally Under Way?
Well, it seems to be turning. Seemingly overnight, small caps are on fire – up more than 11% in the last week, with five straight up days prior to Wednesday’s trading. Unlike the S&P or the Nasdaq, the Russell still trails its late-2021 highs. But it’s gaining on it – fast.
So what changed? The Fed.
OK, so the Fed didn’t change exactly. But better-than-expected inflation numbers last week prompted some fairly dovish talk from Jerome Powell (by his standards), prompting economists to all but pencil in the first interest rate cut in September – the CME Group’s FedWatch Tool now puts the odds of at least one rate cut by the September meeting at 98%, up from roughly 66% just a couple weeks ago. Interestingly, the large-cap indexes are flat (S&P) to down (Nasdaq) in the week since the CPI print, while small caps are up double digits. Could it be a changing of the guard?
Here’s my take: Small caps have merely been a microcosm of “the rest of the market” outside of the Magnificent Seven and a handful of leading artificial intelligence stocks. Indeed, the performances of the Russell 2000 and the Equal Weight S&P Index have been almost identical since the start of 2022; both are up marginally (less than 5%), with virtually all of their gains coming in the past week.
Essentially, the Russell is simply the S&P 500 minus the 10 mega-cap tech stocks that have been propping it up for the last 21 months. We’ve written several times in this space about how nine of the 11 S&P sectors are undervalued despite the market being at all-time highs. The same goes for small caps. So now that the tide appears to – maybe, possibly – be shifting from the Mag. 7/AI to everything else, small caps – perhaps due to their higher upside and general history of outperformance – are leading the charge.
So yes, with rate cuts now finally in sight (it seems), I believe the long-awaited small-cap rally has arrived. Thus, I’ll be on the lookout for potential small-cap additions to the Growth/Income Portfolio of my Cabot Value Investor advisory in the coming weeks. To learn their names and to find out what else I’m currently recommending in this “growth at value prices” newsletter, simply click here.
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