Smaller companies may find it easier to pivot and make changes in an inflationary climate, which is one of the grounds for why small size stocks may outperform large cap stocks.
Will small-cap stocks outperform the market?
Small-cap stocks tend to thrive during young bull markets, when stocks are rapidly heading higher, due to their increased volatility. As shown in the figure below, the Russell 2000, which tracks the performance of small-cap equities, has outpaced the much bigger S&P 500 by a wide margin since bottoming out on March 18, 2020.
It’s worth mentioning that the Russell 2000 is still trailing the S&P 500 in terms of year-to-date performance in 2020, with the index falling 43 percent vs only 35 percent for the S&P 500. Small-cap volatility clearly swings in both directions.
Similarly, during the heady days of the post-financial-crisis bull market, the Russell 2000 outpaced the S&P 500 by a significant margin. The graph below depicts the bull market’s first year.
Will small-cap stocks perform well in 2022?
- Vanguard’s option for following the U.S. Small-Cap Value portion of the market passively is VBR. It charges a low 0.07 percent fee and has been around for nearly 18 years.
- Small-Cap Value equities had a great comeback last year, outperforming Small-Cap Growth by 22.40 percent but still keeping up with the Large-Cap Blend Indices’ robust performance.
- Small-Cap Value stocks are not only cheaper than Small-Cap Growth firms, but they also have comparable earnings growth rates and profitability levels, thus the outperformance should continue through 2022.
- VBR, on the other hand, may not be suitable for risk-averse investors. It’s dominated by equities with a high beta that are inflation-friendly. This could turn out to be a problem if the Fed’s guidance changes.
- Nonetheless, the positives outnumber the problems, so I’m keeping my bullish rating on VBR.
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Are small-cap stocks underappreciated?
After months of underperformance compared to large caps, Jonathan Golub, chief U.S. equities strategist and head of quantitative research at Credit Suisse Securities, wrote in a note Monday that U.S. small caps stand out as an undervalued area of the market.
Do mid-cap companies fare well in an inflationary environment?
We believe the perfect storm will eventually pass, and structural forces such as efficiency-creating technologies will reassert themselves, exerting downward pressure on costs. Positive base effects are likewise disappearing as the inflation “math” shifts in the opposite way. In other words, the high year-over-year readings in 2021 are a result of a very low starting position in 2020, since we witnessed deflation during the pandemic’s peak. When this effect diminishes, which will most likely happen in early 2022, the year-over-year readings will be influenced by a higher beginning point.
However, given the remarkable events of the previous 18 months, we simply do not know how long these supply and demand imbalances will persist. How should investors manage their portfolios now that inflation is still a concern?
According to our findings, stocks do well during periods of greater inflation. We looked at rolling 12-month average total returns for major U.S. equities style/cap indexes over various inflationary (headline CPI) periods, ranging from less than 1% to over 4%. When inflation is over 1% but under 4%, the research implies that stocks do well in general. In low-inflation eras, growth companies tend to hold up well, while in higher-inflation conditions, mid-caps and value stocks tend to outperform.
While we expect inflation to return to the 2% to 3% level by the middle of next year, it is remaining higher than we anticipated. We attempt to limit inflation risk by favoring equities over bonds in our portfolios and emphasizing U.S. mid caps across equity allocations.
Are small-cap stocks a good bet?
- Small-cap equities have a stronger growth potential than large-cap firms, and small-cap value index funds outperform the S&P 500 over time.
- Small-cap stocks are also more volatile than large-cap stocks, and individual small businesses are more likely to go bankrupt.
- Small-cap stocks are best suited to investors who are willing to take on greater risk in exchange for a bigger potential return.
Are small-cap stocks affected by interest rates?
Small-caps, on the other hand, may stand out if long-term interest rates climb faster than short-term rates in the coming year, resulting in a steepening of the yield curve. This is because small-cap indexes have a stronger value bias than the S&P 500’s megacap, long-term growth stocks.
Is now the appropriate moment to buy a small-cap fund?
In general, you should only invest in mid- and small-cap plans if you have a seven- to ten-year investing horizon. In addition, you should have a greater risk profile. You should be able to handle a lot of change.
Do small-cap stocks outperform during a downturn?
There’s always a reason to examine tiny caps, but now might be an especially appealing time to do so. Small caps are benefiting from economic factors and good relative prices as the post-pandemic recovery continues.
In the years following a recession, small caps have historically outperformed their larger brethren. This is attributable to, among other things, small caps’ more locally oriented exposure and higher operational leverage. Consider the early 2000s dot-com bubble. Small caps1 outpaced large caps2 by 42 percent in the three years after the bear market. Following the global financial crisis of 2008, a similar tendency emerged (GFC). Small caps outperformed large caps by 32% in the three years following the GFC.
While past performance is no guarantee of future results, the 2020 pandemic-induced equity market decline is similar to these two prior bear markets. As the economic recovery from the Covid epidemic continues, small caps may be well positioned to deliver strong results. In fact, small-cap equities have outperformed their larger counterparts in the third quarter of this year.
Since the spring of 2021, small caps have trailed large caps as the market leadership has shifted away from cyclical, value-oriented segments and toward more growth-oriented segments. This shift was motivated, in part, by fears about the economy’s recovery as a result of inflation and supply-chain issues. Nonetheless, there’s reason to assume that the small-cap outperformance cycle isn’t over it’s simply taking a breather.
For one thing, more infrastructure spending is likely to benefit industries that are more heavily represented among small caps, such as industrials, energy, and utilities. Furthermore, corporations currently have large amounts of cash, which we believe will contribute to a rise in capital spending and merger and acquisition activity, both of which should favor smaller-cap stocks. Small caps are ideally positioned to potentially lead markets higher as inflation and supply-chain issues are resolved over time, allowing for more spending and investment.
Favorable small-cap valuations
While economic trends favor small caps, the asset class’s relative prices are also enticing. Small-cap stocks are currently trading at their widest discount to large-cap stocks in 20 years. The small-cap discount to large-cap indexes has widened in recent years, owing to the divergent sector compositions of the large- and small-cap indices in the United States.
The information technology (IT) sector, for example, has a much higher weighting in the S&P 500 Index, a growth category that has thrived in recent years. The Russell 2000 Index, on the other hand, has a bigger weight in the financials sector, a more value-oriented sector that has underperformed. Notably, after reaching a similar level of “cheapness” in early 2001, small-cap stocks beat large-cap stocks by a significant margin over the next three, five, and ten years. 3
Small cap and fixed income an unlikely couple
Increasing small-cap equity exposure alongside fixed income could help minimize the low-risk fixed-income investment’s negative impact on expected return.