Broker Check

Buying Up Small- and Mid-Cap Stocks in Dominant Fashion

| April 02, 2024

Market lovers, beware. Bull markets can be boring.

It's exciting to watch account values balloon, however, usually not much changes on a weekly or daily basis. That’s been the case since November, when the latest rally started.

For weeks this blog may have resembled a broken record in that our message has been consistent, slightly repetitive, and perhaps even “boring.” From a market analysis standpoint, boring can be good (and since November it has been).

A couple weeks ago the Federal Reserve indicated interest rate cuts are on the horizon (more on that in a bit). When they occur or how big they are isn’t as important as that they take place at all, at least from the market’s perspective, which is obvious in more upward market performance since rates peaked.

Simply put, the charts don’t lie. Looking at the S&P 500* since November 2023, clearly the beast is roaring:

Every sector has flourished in that time, with growth-heavy sectors leading the way:

This action is both boring and exciting. It’s boring because we’ve been covering many of the same topics for a while, almost like a broken record. The excitement is obvious – markets are way up.

Ever since huge December 2023 buying, there’s been consistently healthy buying without any outsized selling:

If there’s a singular cause of the repetitive narrative, it’s the data in the above chart.

Investors have been awaiting signals from the Fed about rate cuts. Now that we have those, what’s next? We can glean clues from “big money” institutional investors, who’ve been buying up small- and mid-cap stocks in dominant fashion:

The “small growth” theme is somewhat new compared to the past 15 years. But we expect it to continue through into 2025.

First, companies in the Rusell 2000# are expected to grow revenues faster than the S&P 500 by a large margin in 2025 versus 2024 across every quintile:

Additionally, median per-share earnings growth for smaller stocks should outpace the S&P 500:

Faster sales and earnings growth may surprise some who view smaller companies as growing slower. But this forecast’s drivers are sustainable:

  1. The Fed is easing, improving credit liquidity.
  2. A bottoming ISM Manufacturing Index typically leads to a cyclical upturn.
  3. Global inflation ebbing improves confidence.
  4. The most recent earnings calls show CEO caution is ceasing.

Second, small-cap valuations are attractive relative to larger stocks across all quintiles:

Furthermore, the current price-to-book discount for small-cap stocks versus the S&P 500 is 44.0%. The last time it was that dramatic was 1999, at the exact bottom of the last small-cap growth cycle.

Does a 41.0% P/E discount or a 44.0% price-to-book discount make sense? We don’t think this is a “cheap for a reason” scenario. Shouldn’t small-cap stocks be trading at a valuation premium given their higher revenue and earnings growth?

Additionally, as CEO confidence recovers, low valuations should result in significant mergers, acquisitions, and consolidation within those sectors. Historically, we can point to 1999. Back then, all this data was nearly identical and led to a cumulative 113.0% outperformance in 12 years:

A final reason for small-cap enthusiasm is they’ve essentially been abandoned by “big money” investors. As investment analyst Bob Elliott points out, investors have multi-decade low allocations to small caps, even considering the outperformance this year:

We see this as a perfect setup for performance chasing and “FOMO” (fear of missing out) to sustain small-cap growth via institutional money flows. There may be some natural volatility ahead with earnings season complete, but the longer-term trend is clear: risk on for equities as falling interest rates help stocks with higher debt service on their books (i.e., small caps).

Also, lower rates stimulate consumer buying, which ultimately falls to the bottom lines of these types of companies. Smaller growth companies often benefit handsomely at the beginning of a lower rate cycle.

Interesting Setup in The Bond Market

Clearly the Fed’s dovish pivot can be an equities tailwind. Valuable too is the Fed “dot plot” released a week ago as it delivered more thunder to the bullish narrative for stocks and created an interesting setup in the bond market.

Prior to the Fed’s meeting, equity funds suffered $22 billion of outflows, the most since Dec. 22. This is interesting because the prior week attracted record inflows. But many investors were convinced the Fed would reduce the number of 2024 rate cuts from three to maybe zero, creating bearish bets.

This trepidation led bond and stock investors to buy into the “higher for longer” narrative. But the Fed’s new dot plot discredits the “higher for longer” narrative:

Bloomberg defines the dot plot as “a chart showing estimates of what the federal funds rate should be going forward. Members of the rate-setting committee each assign a dot for what they view as the midpoint. As many as 19 monetary policymakers can contribute to this dot plot.”

From the chart above, the median long-term forecast for the federal funds rate is 2.5%. That is compellingly bullish for bond investors because short-term interest rates would be halved from current levels over the next few years, meaning bond prices will trade markedly higher. Furthermore, the CME FedWatch Tool shows a 67.0% probability of a 0.25% cut at the June 12 Fed meeting.

If the Fed is right about the long-term trend and the CME tool is right on the short-term trend, there isn't much time to lock in today's longer-term yields. Income investors must decide how to lock in yields without taking undue risk from longer durations.

Given current yields (below), we’d argue the additional 18-27 basis points from 20-year and 30-year Treasurys over the 10-year isn't worth the additional risk.

If short-term rates hit 2.5% over the next three years or so, the sweet spots moving forward will be 7- to 10-year maturities, offering a strong balance of risk versus reward.

 

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* The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market.

# The Russell 2000 Index is a stock market index measuring the performance of the 2,000 smaller companies included in the Russell 3000 Index and is widely regarded as a bellwether of the U.S. economy.

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