Are Small Caps Poised to Lead Again?

Posted by Dana Funds Investment Team on Apr 17, 2020 9:47:21 AM

While 2020 has been rough for all stocks, the pain has been most acute among small caps. As of April 15, the Russell 2000 Index was down -28.73% this year, a little more than twice the drop of the Russell 1000. While losses have been painful, we would encourage investors to stay patient; there is a strong case for small caps to take a market leadership position in the months ahead.

That case starts with relative valuations. Small caps have historically had higher valuations than large caps, but the valuation differential between the two groups is in the 21st percentile.¹ In plainer terms, that means the valuation disparity between small and large caps is this close less than a quarter of the time. Following these cheaper relative valuation extremes, small caps tend to recover.

The stage in the market and economic cycle also augur well for small caps. As Jefferies Group notes in a first quarter equity research report, small caps tend to beat large caps after the market bottoms and have also outperformed large caps in the year following a recession nine out of the last 10 times. A reason for this is that the economy tends to rebound at an above-average pace coming off a trough, and smaller companies tend to show greater sensitivity to GDP growth.

Another factor that portends well for small caps is the impact low rates could have on the housing market. This has a big effect on small caps, as nearly a third of such stocks are tied to the housing industry, Jefferies notes.

Finally, small caps are typically sensitive to credit spreads, and Fed policies to support a recovery across the credit spectrum could help buoy the market cap segment.

While it is impossible to predict exactly when small cap stocks will outperform large caps again, the current environment may be setting them up to return to their historical market leadership position. Investors should give it time.

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¹Jefferies SMID-Cap Strategy: 1Q20 Recap Slides, April 3, 2020.

The Dana Funds are distributed by Ultimus Fund Distributors, LLC. There is no affiliation between Ultimus Fund Distributors, LLC. and the firms referenced in this blog post.