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There’s light at the end of the tunnel for small caps, analysts say

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The most closely watched U.S. stock indexes have spent much of July hitting new record highs, but the success of the larger U.S. companies that compose those benchmarks have overshadowed the struggles that have plagued small and mid-sized businesses for nearly a year.

But there is reason to believe that the long, cold winter for small-capitalization stocks may be close to ending, analysts say, as rock bottom valuations, expectations of a weakening dollar, and shrinking high-yield spreads act as a catalyst for small cap outperformance in the months ahead.

The Russell 2000 index RUT, -0.62% which comprises roughly 2,000 U.S. companies with market capitalizations below $10.1 billion and a median market value of $791 million, hit a record high way back in August of 2018, before entering a bear market that sent the index as much as 27.2% lower last December.

Even after rising 15.4% in 2019, the index remains mired more than 10% below its previous high, in stark contrast to the Dow Jones Industrial Average DJIA, -0.27% S&P 500 index SPX, -0.46% and Nasdaq Composite index COMP, -0.22% , all of which set new record highs in recent days.

Steven DeSanctis, equity strategist at investment bank Jeffries Group, wrote in a note to clients Wednesday that while he doesn’t see the Russell hitting a new record this year, he has raised his year end target for the small-cap index to 1,665, or a 6.4% increase in the second half of 2019, compared with flat growth for the S&P 500.

“Our relative valuation model now stands in the 17th percentile, and the last time small was this cheap was back in mid 2003,” he wrote. When small cap stocks have been this cheap relative to large cap stocks, “they tend to beat large by 6.4% over the next year, and have done so 78% of the time,” he added, a sharp reversal from the 15% underperformance small cap stocks have posted during the past year.


Lori Calvasina, head of U.S. equity strategy at RBC, pointed out in a recent research note that these cheap valuations are coincident with other metrics pointing to better performance for small-cap stocks in the month ahead. Of the Russell 2000 companies that have so far issued guidance for second-quarter performance, 60% were negative pre-announcements. “That is down from 73% in the first quarter and is also below what we’re seeing in large cap,” she wrote.

Meanwhile, companies in the Russell 2000 index are expected to regain faster earnings-per-share growth relative to the S&P 500 beginning in the third quarter of 2019 and into next year, with earnings growth of 20.2% expected for the Russell 2000 in 2020, compared with 14.3% growth for the S&P 500.

One reason for better earnings growth is simply easier comparisons: small cap underperformance in 2019 will give way to better relative earnings growth in 2020. But DeSanctis also points to a shift in Federal Reserve policy as a new development that will benefit small cap stocks disproportionately.

“Looking at the last 12 times the Fed cut interest rate going back to 1945, small beats large . . . 75% of the time,” he wrote.


The main reasons for this outperformance, DeSanctis argued, are that Fed easing tends to lead to a weaker dollar, which helps small, domestically-focus firms more than their larger, international peers, and because lower interest rates tend to disproportionately lower borrowing costs for small firms.


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