Is January's US Small-Cap Equity Performance Sustainable?
Yes, we expect US small-cap equities will outperform US large-cap equities this year. Our view is based on the belief that the large valuation spread that exists will likely narrow and that large company earnings are likely more at risk of missing expectations than small company earnings. To overweight small-cap equities, we recommend funding it from US mid- to large-cap equities, and we favor either an active manager approach or a passive approach with a quality bias.
US small-cap equites returned 9.5% in January, outpacing their large-cap peers by 3.2 percentage points (ppts), according to S&P indexes. The large absolute performance last month followed a difficult 2022, and it came as expectations for the path of interest rates shifted downward, indicating investors believed future Federal Reserve decisions would be less restrictive than they previously expected. That shift in expectations supported all risk assets and was due, in part, to data pointing to a continued downtrend in inflationary pressures.
A key reason why we like US small-cap equities is the large valuation spread. At the end of January, US small caps traded at 14.3 times trailing earnings, while US large caps traded at 21.7 times. The spread, or difference, between those two multiples is 1.8 standard deviations wider than its long-term average. Excluding today, large valuation spreads are clustered in three distinct periods (the 1970s, 1990, and 1999–2000), and adopting an overweight in each of those periods generated attractive excess returns.
Neither correcting for differences in sector exposures nor adjusting for extreme valuations among some very large companies offsets the valuation spread materially. Regarding the former, it is true that some sectors do tend to demand higher multiples than others and the blocs have different sector exposures. Even after accounting for these differences, the valuation gap remains stretched. Similarly, even if you excluded the five, ten, or 25 largest US companies, large caps would still trade just under 21 times earnings.
In our view, the outlook doesn’t justify a large valuation gap. Small-cap earnings have grown at a similar pace to large caps (9.2% versus 8.7%) over the last 20 years, and analysts are currently estimating negligible 2023 earnings growth for both blocs. However, those negligible growth expectations depend on stable profit margins, and profit margins for large-cap companies are particularly stretched at present. As a result, higher financing and labor costs, as well as the potential for weak demand, may pressure large-cap margins to a greater extent.
But much of the earnings negativity is expected in first half 2023. If US economic activity picks up in second half 2023, which is the current consensus expectation, small-cap equities may benefit to a greater extent than large caps. Looking at data since the early 1970s, small caps have outperformed large caps as US leading economic indicators have recovered 60% of the time and by an average margin of 5.0 ppts.
Still, risks exist for small-cap equities. For one, the bloc is overweight industrials, financials, and consumer discretionary sectors, which tend to be highly cyclical. A deep downturn may lead to small-cap underperformance. The bloc also has less exposure to international markets. In fact, 80% of small-cap revenue is generated domestically, while the same figure for large caps is 60%. A decline in the dollar or better-than-expected growth outside of the United States may also lead to small-cap underperformance.
On balance, we believe current prices compensate for these risks. The best way to get exposure to US small-cap equities is either via an active manager or a passive vehicle with a quality bias. As Cliff Asness and his colleagues at AQR Capital Management noted, the small-cap premium matters “if you control your junk.” 1 But the dispersion of valuations among small-cap companies is also wide at present. This may provide greater opportunity for thoughtful strategies to generate solid returns.