Why Small Caps Have Underperformed Big Caps and How the Tide Could Turn
For nearly two years, small-cap stocks have been struggling to keep up with big-cap stocks due to concerns about interest rates. Despite historically outperforming large caps over the past 25 years, small-cap stocks have faced challenges in recent times. However, there are signs that the tide could be turning in their favor.
Since September 2021, small-cap stocks have lagged behind blue chips for an extended period, losing almost a fifth of their value while large caps gained around a fifth. This has been the longest period of underperformance since the turn of the millennium. While small caps have stabilized in the past twelve months, there is optimism for a potential small cap comeback in the near future.
The Impact of Rising Interest Rates on Small Caps
The chart below illustrates the impact of bond yields on the performance of small and mid-cap stocks. It shows that small caps have struggled since interest rates started rising, leading to their underperformance compared to large caps.
Sources: LSEG Data and Analytics, DWS Investment GmbH as of 3/15/24
There are three key periods highlighted in the chart:
- Until mid-2021, small caps’ performance was driven by earnings estimates.
- From mid-2021 to autumn 2022, a downward trend was observed in small caps’ relative performance, earnings estimates, and interest rates.
- Since autumn 2022, small caps’ performance has been closely tied to interest rate trends.
One surprising aspect of small caps’ struggle has been the negative impact of rising interest rates. While small caps are typically more cyclical than large caps and should benefit from a healthy economy, this time they have faced challenges due to various factors. The European Central Bank’s interest rate hikes, driven by high inflation rates, and concerns about small caps’ sensitivity to refinancing costs have contributed to their underperformance.
Debt Dynamics and Profit Outlook for Small Caps
One key factor affecting small caps’ performance is their debt structure and duration. Small caps tend to have lower duration debt, which means they are more vulnerable to rising interest rates. As borrowing costs have increased rapidly, small caps have felt the impact more than large caps, which rely more on bonds with longer maturities.
Despite these challenges, there is optimism for small caps’ earnings growth. Analysts expect double-digit earnings per share growth for small caps in 2024 and 2025, outpacing large caps. This positive outlook suggests that small caps may see a turnaround in their performance in the coming years.
In conclusion, while small caps have faced headwinds in recent times, there are reasons to be hopeful for their future performance. As interest rates stabilize and earnings growth prospects improve, small caps could be poised for a comeback in the stock market.
The performance of blue chips and small caps is showing a significant gap in terms of relative earnings growth, as indicated by recent data. Additionally, small caps are falling behind in risk premiums on corporate bonds, further highlighting the disparity between the two sectors.
In terms of price performance, small cap stocks are also struggling compared to the development of risk spreads on high-yield bonds. Despite a tightening spread in recent months, the correlation with small cap stock prices has not been consistent during this period.
Last year, small caps were historically undervalued, and this trend has continued into the current year. The price/earnings ratio based on estimated earnings for the following twelve months shows that small caps are now trading at a discount of almost 10% compared to blue chips. While a return to previous average levels may not be feasible, even a return to a level without a premium or discount could benefit small caps in the relative market.
It is essential to consider the differing opinions on the performance gap between small caps and blue chips. Equity analysts and bond investors may need to reassess their earnings estimates and expected returns to understand why the gap persists. Alternatively, other factors may be influencing the struggles of small caps in the current market environment.
One significant challenge for small caps is the dominance of heavyweight stocks in various sectors, such as technology, luxury, pharmaceuticals, consumer goods, and technology. The “winner-takes-it-all” investment landscape has favored large players, leading to rapid growth and market dominance. This dynamic has impacted the performance of small caps, which have faced higher losses compared to large caps in recent months.
The momentum investment style has also played a role in the market, outperforming overall market performance since last summer. This trend has favored momentum stocks, with a significant gap in gains compared to the broader market. Investors looking to protect against concentration risks may increasingly seek strategies to mitigate potential losses in this environment.
In conclusion, the current market dynamics favoring large caps and momentum stocks have posed challenges for small caps. DailyBubble’s perspective is that investors should carefully assess market trends and consider diversification strategies to navigate the evolving investment landscape effectively.