One of the silver linings of the type of volatility that’s occurred over the past year is that it also creates opportunities amidst the carnage. An area that we believe is shaping up to be one of those opportunities is US Small Cap stocks, for several reasons.
The first is that they’ve experienced an even bigger valuation “re-set” than Large Caps have in this bear market. The forward price/earnings ratio for Small Caps bottomed around 11x last year, which was similar to the level reached in the pandemic plunge and just a little above the depths of the GFC in 2008. It’s risen a little to 12.5x currently, but that’s still quite low and remains at a significant discount to Large Caps. Our own valuation model suggests this is the most attractive that Small Caps have been versus Large Caps since 2000-01.
Next, other factors that should provide a tailwind for small caps as this year unfolds are lower inflation and eventually a steeper yield curve. Inflation is already cooling, which should allow the Fed to pause its rate hiking campaign in the first few months of 2023. Once that happens, the market will start to look ahead to future rate cuts and begin to price those in (just as it priced in rate hikes last year far faster than the Fed actually moved), and the yield curve would start to re-steepen with short-term rates falling again. This would suggest the economy is passing through the nadir of its slowdown phase and soon to be entering a new growth cycle, and Small Caps happen to be early cycle performers historically.
Lastly, the composition of Small Cap indices look different in that they generally have less exposure to Growth sectors like Technology & Communication Services, and more exposure to Value sectors like Financials & Industrials. In addition, they have no exposure to the popular mega-cap stocks that have transitioned from market leaders to laggards over the past several months.
Carl Noble, CFA®
Senior Vice President of Investments
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