US Small-Caps Lag Behind In Market Race

Small-cap stocks in the US face their largest performance gap against large-caps in over two decades.

Why are small-cap stocks underperforming in the US?

For the first time in over two decades, US small-cap stocks have significantly underperformed compared to their large-cap counterparts, delineating a stark contrast in investor confidence and market dynamics. The Russell 2000 index's growth of 24% since 2020 pales against the S&P 500's surge of more than 60% within the same timeframe. This divergence deviates from the historical trend where small-caps, despite their higher volatility, have been the favorites for their potential for outsized returns. The gap underscores the prevailing challenges faced by smaller companies, including heightened inflation and borrowing costs, which have diminished their appeal among investors.

Shifts In Market Dynamics And Investor Sentiment

The financial landscape has seen significant shifts, with investors gravitating towards megacap technology stocks, leaving small-caps to grapple with the repercussions of high interest rates. This change in focus has stymied the growth of small-caps, historically buoyed by their agility and potential for rapid expansion. Greg Tuorto of Goldman Sachs Asset Management reflects on the absence of "animal spirits" since 2016, indicating a need for a more vibrant M&A and IPO market to reignite interest in small-caps. Meanwhile, the tech boom, spearheaded by companies like Nvidia and Meta, has only widened the performance chasm, despite a fleeting rally among small-caps in late 2023.

A Glimpse Into The Past And The Road Ahead

The precedent for small-cap stocks outperforming larger ones traces back to the 2000s, a period characterized by lower global interest rates and the inefficiencies of a less scrutinized market. However, the persistent challenge of inflation and a strong jobs market have led to an adjustment in expectations for interest rate trajectories. The Federal Reserve's cautious stance on rate adjustments hints at a prolonged period of high rates, further complicating the outlook for small-cap entities, especially those burdened with short-term or floating-rate debt.

Earnings Divergence And Future Prospects

The disparity in earnings growth between Russell 2000 companies and their S&P 500 counterparts further illustrates the divide, with small-cap earnings falling by 17.6% year-on-year in the fourth quarter, as opposed to a modest increase among S&P companies. Yet, there's optimism for small-cap sectors, predicated on easing interest rates and an improving access to capital. Bank of America's Jill Carey Hall suggests that the current valuation gap between small and large caps could herald a promising era for small-caps, reminiscent of the rebound seen in the early 2000s.

The contrast in performance between US small and large-cap stocks marks a significant shift in market dynamics, reflective of broader economic challenges and investor preferences. While the current landscape poses hurdles for small-caps, the evolving economic indicators and potential for market correction present a nuanced outlook. As interest rates and market conditions adjust, the resilience and inherent potential of small-cap stocks may once again come to the fore, redefining their role in investors' portfolios.

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