Small-Cap Stock Recovery: What Investors Need to Know Post-Q2 Reporting Season
In the wake of the Q2 reporting season, the recovery in fundamentals for small-cap companies may take longer to materialize, according to analysts at brokerage firm Strategas. Through the end of the first quarter, expectations for earnings per share (EPS) growth in small caps are projected to lag behind large caps, dimming the overall optimism for these stocks.
Strategas analysts suggest that if the decline in small caps following the first Federal Reserve rate cut is less severe than in large caps, it might be prudent to consider adding exposure. However, they caution that maintaining a fundamentally constructive stance on small-cap stocks remains challenging.
Historically, small-cap stocks tend to underperform large-cap stocks by about 400 basis points as the business cycle peaks and begins to contract. Large-cap companies generally have easier access to capital and stronger cash flows, further widening the performance gap.
The current market environment could exacerbate this disparity, as approximately 40% of the Russell 2000 index hasn't turned a profit in the past 12 months. Despite these challenges, historical data shows that small caps have outperformed large caps in all six recessions since 1980. On average, small caps outperformed large caps by 1,400 basis points on a forward 12-month basis from the recession's trough, as designated by the National Bureau of Economic Research (NBER).
"The difficulty here is that the 'end' of a recession is only clear in hindsight," Strategas analysts note. "But the story still stands that small-cap stocks are typically more leveraged to fluctuations in the U.S. economic cycle's rate-of-change than large-cap stocks."
In July, small caps experienced a strong month relative to large caps. However, concerns were raised earlier in the month due to the lack of participation from high relative low-beta stocks. Consequently, more than two-thirds of the relative outperformance have reversed, with small caps struggling during August's market sell-off.
"Until durable fundamental improvements form, we’d refrain from putting capital to work in the small-cap asset class at the expense of large cap exposure," Strategas concludes.
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Breaking It Down: What This Means for You
Who Should Care?
- Investors in Small-Cap Stocks: If you have investments in small-cap stocks, this analysis is crucial for your portfolio strategy.
- Potential Investors: If you're considering investing in small-cap stocks, understanding these dynamics can help you make informed decisions.
Key Takeaways:
- Delayed Recovery: Small-cap companies are expected to take longer to recover post-Q2 reporting season.
- Performance Gap: Historically, small caps underperform large caps during economic contractions due to less access to capital and weaker cash flows.
- Market Environment: The current market could widen the performance gap, with many small caps not turning a profit recently.
- Recessions: Small caps have historically outperformed large caps during and after recessions, but timing the end of a recession is difficult.
- Current Trends: Recent performance indicates a struggle for small caps, particularly in August.
How It Affects You:
- Investment Strategy: Be cautious with small-cap investments until there are clear signs of durable fundamental improvements.
- Portfolio Diversification: Consider balancing your portfolio with large-cap stocks that have stronger fundamentals and are less volatile.
- Market Timing: Understanding the economic cycle and its impact on small caps can help you better time your investments for optimal returns.
By grasping these insights, even the most novice investor can navigate the complexities of small-cap stocks and make more informed financial decisions.