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Written by: Stephanie Aliaga and Stephanie Aliaga
Mega-cap tech has enjoyed a long winning streak, but the stars recently began to align for the underdogs to take the lead. Expectations for disinflation, a September rate cut, resilient growth and a potentially more favorable tax and regulatory environment under a Republican Sweep all contributed to the significant rotation in the markets that has followed the June CPI report. Many areas of the markets benefitted, but small cap stocks were a standout. Since July 12, the Russell 2000 has returned +4.5% while the S&P 500 is down -0.3%.1 Can this performance continue?
Weak fundamentals prevail: small caps are less profitable and more rate sensitive than their larger counterparts.
High interest rates have pressured many areas of the economy, but small caps have been acutely exposed given higher debt burdens. An elevated number of small cap companies are currently unprofitable and a larger proportion of their debt is floating rate, leaving interest coverage ratios much weaker than that of mid and large caps (See GTM Page 13).
However, higher rates haven’t always been the downfall for small cap. Historically, higher rates have been associated with small cap outperformance.2 This is because when rates were rising for “good” reasons (i.e. strong economic growth), small caps tended to see their earnings grow faster than the burden of rising interest costs.
As such, growth matters more than rates, but we’re not convinced it can come to the rescue this time. Small cap earnings growth should inflect from negative to positive in 3Q24, but analysts are expecting a robust 21% y/y growth for the S&P 600 in 4Q24 with high double-digit growth projected through 2025. There doesn’t seem to be a catalyst for earnings this strong— GDP growth is slowing and the Fed’s easing cycle should be gradual. Indeed, small cap earnings estimates have already been revised down significantly, and there’s likely more to come.
Small caps are trading at a discount, but a cheap stock is not necessarily a good stock.
Relative to the S&P 500, the S&P 600 is currently cheaper than it has been 80% of the time over the past 25 years.3 Perhaps small caps are unduly priced for the “worst”. Debt burdens are elevated, but at 4.4x EBITDA they are still below their 10-year average of 4.8x, and Fed easing could provide some refinancing relief.4
Small caps also offer opportunities for alpha--80% of the universe is either thinly covered by analysts or not covered at all.5 Granted, thinly traded markets leave investors exposed to volatility and technical factors too. The magnitude of the recent small cap rotation has been partially attributed to hedge funds working to close a near record number of short positions.
We think there may be room for small caps to recover off depressed valuations. However, small cap fundamentals remain muted, and sometimes, you get what you pay for. Valuations alone are not a strong indicator of small cap returns. While the forward price-to-earnings ratio can explain 26% of the five-year return for the S&P 500, it has almost no predictive power for the S&P 600.
Overall, it seems like valuations may be the only particularly exciting thing about small caps right now. While we believe market performance will continue to broaden outside of mega-cap tech, the strength of the rotation into small caps seems premature given weak fundamentals. Instead, lesser-loved areas of large cap or mid cap markets may provide better grounds for opportunity.
Note: The Russell 2000 and the S&P 600 are the most commonly used small cap benchmarks. In the below chart, we show the S&P 600, which is rebalanced quarterly and represents a higher quality index compared to the Russell 2000. Since the S&P 600 requires a company’s trailing four quarters of earnings to be positive at the time of inclusion, it often trades at cheaper valuations than the Russell 2000, which is based solely on market cap and is rebalanced annually.
Small cap valuations and subsequent 1yr & 5yr returns
S&P 600 Total Return Index; forward P/E (x-axis) and subsequent returns (y-axis)
Source: Bloomberg, FactSet, Standard & Poor’s, J.P. Morgan Asset Management. Returns are 12-month and 60-month annualized total returns, measured monthly, beginning 12/31/1994. R² represents the percent of total variation in total returns that can be explained by forward price-to-earnings ratios. Price-to-earnings is price divided by consensus analyst estimates of earnings per share for the next 12 months as provided by Bloomberg. Data are as of June 24, 2024.
1Market returns reflect the period between 7/11/24 (the date the June CPI report was released) and 7/22/24.
2As measured by the correlation between the Russell 2000 / 1000 index and the 10-year treasury yield. From 12/31/1979-12/31/21, the correlation is 0.18. From 1/3/2022-7/19/24, the correlation is -0.65.
3As measured by the relative NTM P/E ratio of the S&P 600 to the S&P 500 provided by Bloomberg. Values are quarterly from 6/31/1999 through 6/28/2024. The value on 7/22/24 is at the 18th percentile.
4As measured by the Net Debt to EBITA ratio of the Russell 2000 index. Values are monthly from 1/31/2014 through 7/22/2024.
5J.P. Morgan Asset Management, Michael Cembalest. July 23, 2024. “The Lion in Winter.”
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