The relationship between small-cap and large-cap stock performance has historically moved in long, cyclical patterns. Over the past 45 years, there have been three significant cycles, each lasting over a decade. From 1983 to 1999, small-caps lagged behind large-caps, marking a long period of underperformance. This trend reversed between 1999 and 2011 when small-caps outperformed large-caps. Since 2011, however, small-caps have once again underperformed their larger counterparts.
There is a growing consensus that the Federal Reserve’s move toward cutting interest rates could benefit small-cap stocks. Small-cap companies tend to be more domestically oriented and are often more sensitive to cyclical economic changes. As interest rates fall, these companies will have more favorable conditions for managing debt and refinancing at lower rates.
According to the latest National Federation of Independent Business survey, the average interest rate on short-term loans for small businesses has climbed to 9.5%, the highest level in 18 years. A rate cut would provide much-needed relief in this environment, allowing small businesses to lower their borrowing costs and potentially stimulate growth.
Small-Cap Representation Near a 15-Year Low
U.S. small-cap stocks’ representation in the global markets has also decreased, nearing a 15-year low. Using the Russell 2000 as a benchmark, the index now represents only 3.4% of the FTSE All-World Index, down from 4.6% in March 2021.
For an additional perspective, the shrinking share of the market is further highlighted by the fact that Apple’s market capitalization of $3.5 trillion now exceeds the entire market cap of the Russell 2000.
Valuations: Small-Caps Have Become Cheaper
Given the relative underperformance of small-caps over the past decade, their valuations have also become more attractive. When comparing the relative forward price-to-earnings (P/E) ratio of the Russell 2000 to the Russell 1000, small-caps have generally traded at a premium. This premium has been steadily declining over the last decade, excluding a temporary period in 2020.
Furthermore, when adjusting for the healthcare sector—which tends to skew earnings results due to its unprofitability as a sector—the adjusted forward P/E ratio for the Russell 2000 falls to 17.1x, compared to 22.3x for the S&P 500.
Earnings Growth Projections Favor Small-Caps
Looking ahead, small-caps are expected to outpace large-caps in terms of earnings growth. According to LSEG Proprietary Research, year-over-year earnings growth for the Russell 2000 is projected to be 34.2% in the third quarter of 2024, compared to just 5.3% for the S&P 500. Looking further ahead to fiscal year 2025, earnings growth for the Russell 2000 is expected to reach 38.6%, compared to 13.0% for the S&P 500.
The primary drivers of this growth for small-caps are expected to come from sectors including as Financials, Industrials, Energy, Information Technology, Consumer Discretionary, and Health Care.
To subscribe to LSEG Proprietary Research Reports, please visit Lipper Alpha Insight. Our reports are also available in LSEG Workspace.
A Potential Shift in Large-Cap Leadership
Within the S&P 500, there is an expected shift in earnings growth contributions. The Magnificent-7—a group of the largest tech-focused companies—have been responsible for much of the index’s recent growth. For example, S&P 500 earnings grew by 4.1% in 2023, but when excluding the Magnificent-7, earnings growth for the rest of the index fell to -1.3%.
Analysts are anticipating a shift away from the Magnificent-7’s dominance, with more growth expected from the remaining 493 companies in the S&P 500. A lower interest rate environment will likely contribute to this shift, benefiting smaller and more cyclical companies, similar to the expected positive impact on small-caps.
Small Cap StarMine Model Performance
Every month, the StarMine research team publishes a report highlighting how our StarMine models performed. Over the last twelve months, U.S. small caps have performed well with strong decile spreads across all models. We also note that small-cap decile spreads have outperformed large-caps.
Combined Alpha Model (CAM) has shown the strongest performance over this period, with a decile spread of 46.6%. CAM is a multi-factor model which consolidates all of our quantitative alpha models into a single score for each company.
StarMine, offers traditional factors such as Value, Momentum, and Quality, along with non-traditional factors such as ownership, insider, and filings data.
To learn more about StarMine, please visit LSEG StarMine.
Conclusion
While small-caps have underperformed large-caps over the last decade, the current market environment, especially with anticipated interest rate cuts, could provide more favorable conditions for smaller companies. With valuations at near-record lows and earnings growth expected to outpace large-caps, this provides an encouraging backdrop for small-caps.
