By: Dave Chenet, CFA, CAIA
|Close||Weekly return||YTD return|
|US Treasury 10yr Yield||3.73%|
Source: YCharts, Yahoo! Finance, WSJ
Market Recap: Can Small Cap Stocks Catch Up to Large Caps?
As widely reported in financial media, the year-to-date rally in stocks has been led almost exclusively by mega-cap stocks (those with a market capitalization of $200B+). Through the end of May, mega-caps boasted 17% year-to-date outperformance vs their small-cap peers. Small-caps, however, have shown some signs of life so far in June. They have risen over 7% vs. the 2% gain in mega-caps. Is this a blip or a sign of things to come?
We see the potential for small-cap stocks to outperform for two key reasons:
- Mega-caps have rallied on valuation, not earnings: Since the October 2022 recent market low, mega-caps are +26% vs small-caps of +14%. The outperformance has been due to rising valuations –forward price/earnings ratios for mega-caps have improved from 20 at the lows to 30 today, while small-cap stocks are trading with forward price/earnings of 12. Seemingly, small-caps are pricing in a more challenging economic environment while mega-caps have yet to recognize the rising risk of recession.
- Shifting bets on the path of monetary policy: For much of this year, investors have been betting on the Federal Reserve reversing course in the near future and beginning to decrease interest rates. That narrative is beginning to shift as inflation has not fallen as quickly as markets had hoped and a higher interest rate/higher inflationary environment seems more likely. Easy monetary policy has lifted tech-oriented mega-caps and depressed small-caps. The recognition that the Fed may have to remain tighter for longer has helped small-caps begin to catch-up.
In summary, the recent outperformance of small-cap stocks compared to mega-cap stocks in early June may be indicative of a broader trend. Factors such as the reliance of mega-caps on valuation rather than earnings and the shifting expectations of monetary policy have created favorable conditions for small-caps to catch up. However, further monitoring and analysis are needed to determine whether this trend will persist or if it is merely a temporary fluctuation in the market.
What We’re Reading:
Chart of the Week: