November 23, 2020
Summary:  After the recent rise, small caps may be due for a breather near term. However, our work suggests a compelling relative opportunity is at hand for investors over the next 12 months.

Increasing small caps should create an effective barbell between growth and cyclical exposure in our tactical guidance. Our modest large cap growth bias should do well during periods where markets get concerned about uneven economic growth and logistics surrounding the safety and distribution of COVID-19 vaccines. Conversely, we anticipate the small cap position should outperform during periods where investors gain confidence in the economic recovery and vaccine (and underperform during periods of weaker economic growth). Our work suggests that a position in small caps, using the S&P 600 as a proxy, is a better way to gain exposure to the potential reflation trade than via large cap value, given its more cyclical sector composition.

From an intermediate-term standpoint, we see catch-up potential for small caps after an extended period of underperformance. Relative valuations are compelling, comparative earnings trends are rising, relative price trends are improving, and sector composition is supportive. Our work also continues to suggest that we are in the early stages of a multi-year economic expansion, albeit one with an uneven path, which should benefit small caps over time.

Indeed, small caps are a standout across our quantitative work. Even after accounting for some recent improvement, small caps have trailed large caps by double-digits over the past 12 months, among the most extreme periods of underperformance since 1999 (Figure 1).

Consequently, based on a composite of valuation measures, the S&P Small Cap 600 is trading at a discount of 7% relative to its own 5-year median; this compares favorably relative to a current premium of 28% for the S&P 500. Moreover, small caps are trading at the largest discount relative to large caps on a price-to-earnings, price-to-book, price-to-sales and price-to-cash flow basis since the early 2000s (Figure 2). Valuations, by themselves, are not a catalyst; so it is good news that after moving sharply lower during the early stages of the pandemic, small cap earnings trends have been rising relative to large caps for about four months. The improved fundamentals have aided stabilization in relative price trends for small caps since the summer months with a notable uptick since late September (Figure 3).

Also reinforcing this view is sector composition. The S&P 600 has almost 23% of its exposure in materials and industrials, two of our favored sectors. Relative to large cap value, small caps have less exposure to some of the defensive areas, such as staples and utilities, where we have a more mixed outlook (Figure 4). The S&P 600 is not as concentrated in financials as other value areas, including small cap value. What is also notable is that during the most recent sharp value rally, small caps strongly outperformed large cap value—trading to a 19-month relative price high and still remain much cheaper on a valuation basis (Figure 5). This provides further support to our view that small caps are likely to outperform during periods of cyclical rotation.

Among the primary risks to small caps is a weaker-than-expected economic recovery, a delay in vaccine availability, deterioration in credit conditions and a rise in volatility.

Bottom Line

The weight of the evidence in our work suggests a positive view of small caps. We would look to add to positions and view pullbacks as opportunities to accumulate shares and position for the year ahead.

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CN2020-2528 EXP12-2020