Election Year Playbook, Part 2: Buy This Lagging Sector Now

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Last week, we made the data-driven case to buy stocks during the Q1 dip.

Using historical evidence, we showed that weakness in stocks in the first few months of an election year presents a major buying opportunity.

With that narrative in mind, today we’ll take it a step further, diving into one of my favorite areas to own for 2024: small-caps.

Let’s rewind the tape for a moment…

Back on October 19th, we laid out one of our biggest non-consensus calls of 2023 — to buy the lagging small-caps.

At the time, the financial media spun tales of never-ending interest rate spikes, and a surefire soon-to-come recession.

However, at TradeSmith we took the other side of the trade… noting how small-caps were witnessing one of the widest performance gaps to large-caps in recent memory. On top of that, the price-to-earnings levels of the S&P Small Cap 600 sank to one of most attractive levels over the past 20 years.

Get this…

Since that post, small-caps have surged an eye-popping 15.4%, sending the bears into an oh-so-silent hibernation.

Now, with such a monster move, you may assume the group can’t possibly rip further. But you’d be wrong.

After you review the evidence, there’s a case to be made that this unloved area of the market can climb double digits this year.

Let’s start off with the top reason why: they’re still cheap…

Small-Caps Are Still Cheap and on Sale Now

2023 ended on a hot note. The S&P 500 climbed nearly 25% on the year while small-caps jumped 16%.

Since then, the tables have turned with both groups falling sharply. As you can see, the S&P 500 has dropped 1.5% in January while smaller stocks have fared doubly worse with a 3.6% fall: As you may know by now, I’ve a huge believer in buying dips. When the crowd hates something, there’s a decent chance I’ll love it… especially when the fundamental case is supportive.

That’s the current situation with small-caps. Even after the face-ripper in Q4, their valuation is much cheaper than large-caps. And they sport a 20% greater dividend yield.

Below reveals the details. The S&P Small Cap 600 offers a dirt-cheap next-twelve-months P/E of 13.7, compared to the S&P 500’s 19.3 ratio.

Not only does this cheaper valuation make small-cap stocks interesting from a value perspective, they also pack a 20% greater dividend yield vs. larger companies.

The S&P Small Cap 600 is constructed with greater weights in cyclical areas like Financials and Industrials, boosting the dividend yield to 1.79% vs the S&P 500’s yield of 1.44%: So far in 2024, we’re staring at a ripe pullback and better valuations for small-cap stocks. While these two datapoints alone would make for a strong case to own the group, there’s more. A lot more.

You see, as we showed you last week, pullbacks early in the year are uber common for stocks.

However, the bounce back is much stronger for small-caps than large-caps.

Let’s prove it!

Small-Caps Crush Large-Caps in Election Years

Elections bring all kinds of uncertainty to politics. Fresh tax laws and new party leadership are just a couple of considerations that large investors have to juggle.

And when unknowns exist in the stock market, smart traders sell first and ask questions later.

That’s exactly the playbook heading into the vote. There’s a tendency for stocks to struggle earlier in an election year before gathering steam in later months.

BUT small-caps in particular enjoy a much larger surge in the back half of the year.

Since 1996, the S&P Small Cap 600 tends to slightly underperform the large-cap S&P 500 in the first 3 months of an election year with an average fall of 1.4% (small-caps) vs. a drop of 1.3% for larger stocks.

And that’s where the bad news ends. Because after the 3-month mark, small-caps vault higher.

Election uncertainly is a dip buyer’s friend. Small-caps put in an enviable performance of 10% gains in election years… easily trumping the measly 5.8% typical gains in large-caps: As you build your buy list for Q1, make sure to add a few smaller stocks to the mix.

The deeper pullback they’re experiencing today is normal and will eventually end. Not only that, lower valuations and fatter yields give this unloved group higher grades in 2024.

Watching the rerating in small-caps in Q4 gives you an idea of how powerful a small-cap surge can be. In that environment, single names will crush the indices… likely by double or triple.

That’s where you should be hunting as an investor… and it’s where TradeSmith shines. Use our software and analytics to uncover leading stocks poised to thrive in a risk-on tape.

Dips eventually lead to rips…start preparing today!

Lastly, be on the lookout for part 3 of this election year write-up coming later this week. To wrap up, we’ll dive into the sectors you’ll want to overweight in 2024.

Regards,

Lucas Downey,
Contributing Editor, TradeSmith Daily