![The Bull Case for Small-Cap Stocks as the Second Half Begins](https://news7g.com/wp-content/uploads/2024/07/107416634-17159624062024-05-17t152050z_1720978357_rc2ds7azyl70_rtrmadp_0_usa-stocks-780x470.jpeg)
The bull market in small-company stocks remains intact for many investors as they enter the second half of 2024 after a dismal six months. Small-cap stocks were widely expected to outperform this year—they typically do well in presidential election years—and were expected to get a boost from falling borrowing costs as the Federal Reserve began cutting interest rates. Those hopes have instead been dashed. While the S&P 500 has soared to an all-time high this year, thanks to a small group of large-cap tech stocks, rising 15%, the small-cap Russell 2000 index has barely budged, rising less than 1%. The average market value of a stock in the Russell 2000 is just under $1 billion, compared with about $31 billion for a stock in the S&P 500. .RUT YTD mountain Russell 2000 Small-cap companies posted their worst first half of the year relative to large-cap stocks since Richard Nixon was president in 1973, according to Steven DeSanctis, small- and mid-cap strategist at Jefferies. Going back to 1926, it was the sixth-worst first half on record, he added. Still, skeptics say there’s time for small-caps to make up ground, as they did by the end of 2023. Not only is the environment still favorable for small-cap stocks, but they’re also selling at low valuations relative to large-caps, suggesting there’s an opportunity for investors to capture some gains. “Be aware of your allocation. Mainly because, you know, who could have predicted in December that small caps would outperform large caps by 800 basis points. But that’s what happened. 800 basis points in 20 trading sessions. That’s huge,” said Jefferies’ DeSanctis. “You can give up a lot of relative performance pretty quickly.” DeSanctis has a year-end target of 2,180 for the Russell 2000, representing a roughly 7% gain from current levels. By contrast, the S&P 500 has already met Jefferies’ bull case of 5,400, the strategist noted. Elsewhere, the consensus price target for the S&P 500 by year-end among strategists surveyed by CNBC Pro is about the index’s current price. The right catalyst For investors, the bullish case for small caps, which was dominant when the year started, remains intact. The asset class typically outperforms in an election year. U.S.-based companies are expected to benefit from secular drivers such as reshoring of supply chains, and small caps could get a boost once the Fed begins cutting interest rates, which could come as early as September. More immediately, second-quarter earnings could prove to be a positive catalyst for small caps because expectations are so low, according to Jefferies’ DeSanctis. The consensus bottom-up estimate for small caps is for a double-digit earnings decline of 12.4%, while the S&P 500 is expected to see earnings growth of 9%. Small-cap companies have a track record of beating earnings expectations in recent years, the strategist noted, but what could help them now is their slightly higher capital ratios and cash levels than they have historically had. “People worry about small-cap balance sheets,” DeSanctis said. “I worry less.” Valuations For many investors, it’s hard to justify an allocation to small-caps when a handful of large-cap stocks have dominated the market’s bull run. But small-cap advocates say this is the time to trim some of their exposure to the Magnificent Seven, even if the group’s long-term prospects remain bright. “There’s been easy money in the AI space,” said Brian Leonard, a portfolio manager for small- and mid-cap equities at Keeley Teton Advisors. Market watchers expect there could be a rotation into small caps after interest in the group hit a record low. Small caps now account for less than 4% of the entire U.S. stock market, “so it’s like nobody’s there” in terms of investor attention, DeSanctis said, adding that it would take “a little bit of interest” for the group to start performing. Overall, proponents say valuations are attractive. On a 12-month basis, the S&P 500 trades at 25 times earnings. The iShares Russell 2000 ETF (IWM), which tracks the small-cap index, trades at just 14 times. Certainly, other investors are skeptical. While they expect interest rate cuts to be a boon for the asset class, they also say small-cap companies — which tend to be more economically sensitive than larger companies — could get hammered in a recession. “I think we’re going to have to at least get through this period of weakness in the economy before we can get that spark that sends small caps higher,” said Ross Mayfield, investment strategist at Baird. “I would favor larger companies over small companies at this point.” Ultimately, though, many investors think a rotation into small caps is coming, even if it hasn’t happened yet. “There’s a lot of opportunity in small- and mid-cap stocks, a) from a valuation standpoint and B) from an opportunity standpoint, especially with the domestic focus, that could really set up investors well for years to come as the market turns,” said Leonard of Keeley Teton. “The timing of that turn is anybody’s guess, but as we’ve seen over multiple market cycles, the market does turn.” DeSanctis is almost calling out the law of averages. “Something has to go right for small caps at some point,” he said. “At some point, it has to start doing better.”