Small-cap stocks may be less at risk and have more upside potential if the market’s downward trend persists.
While the S&P 500 is down 23.4 percent from an all-time high set in January, the Russell 2000 is down 31.8 percent from November’s record high set in November. With growing inflation and interest rate increases from the Federal Reserve, small-cap stocks have performed less well than their bigger counterparts. In other words, if investors can put their anxieties aside and look forward to better times, small-cap equities may outperform large-cap ones.
There is no denying that small-cap stocks have taken a beating. A 26% decline in 2022 puts the Russell 2000 on pace to record its worst half-year ever. Before today, the worst was in 2020, when the Russell plunged 13%, and then in 1982, when it dropped 11%, and in 1984, when it lost 9.5%. During the second half of each year, the index rose significantly, gaining 38% in 2020, 40% in 1982, and 2.4% in 1984. “The worst first half for small-caps has been followed by the finest second half,” says Jefferies’ Steven DeSanctis.

“Relative oversold” is a term used by 22V Research’s technical strategy director, John Roque, to describe Russell’s slide as more severe than the S&P 500’s. It is expected that small-caps would rebound faster than large-caps.

Due to the S&P 500’s drop this year, the value of the Russell 2000 has been severely reduced. Since its November high of 26.4, an ETF tracking the index has traded at 15.8 times 12-month predicted profits, a 10.6-point drop. The price-to-earnings ratio of the S&P 500 has dropped six percentage points to 15.4 from its January peak of 21.4%. Just over half a percentage point separates the S&P 500’s valuation from Russell’s as of this writing. A five-point difference means that small-cap equities are more resilient to a downturn than large-cap ones, even if the economy is weakening.

Even if the economy continues to grow at a steady pace, small-cap companies might be an excellent investment. FactSet predicts a 20 percent annual increase in the Russell 2000 ETF’s total profits per share in 2023. That’s 2.5 times the expected growth in S&P 500 EPS. Even if the ETF trades at its current ratio, increases in earnings alone would increase its value by 27%.

There is no need to worry about a recession happening in the next 12 months according to Credit Suisse’s senior U.S. equity analyst, Jonathan Golub. That’s a nice notion, even if it looks like wishful thinking at the moment.

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