You’re Running Out of Time to Buy This Sector
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There are plenty of deals in the market. You just need to know where to look.
Last week my business partner Jason Bodner dove into one of the cheapest areas of the market, energy stocks – and showcased why they need to be on your radar now.
Today we’re going to continue on this “value” theme by looking at one of the most hated groups in stockland… small-caps.
Beaten to a pulp, the area has vastly underperformed large-caps since 2021. But as I’ll dive into today, I believe the lagging trend is set to unwind… sending small-caps northbound. That’s one of just two tailwinds set to hit this sector.
Even better than that, small-caps present a tremendous value today, relative to history, that few large-caps can boast.
If you’ve shunned smaller companies… now’s the time to second-guess that position.
One awesome study signals a fat rally is coming. But before we blow the doors down, let’s size up the current landscape for small-caps.
Small-Caps Continue to Heavily Underperform Large-Caps
Higher interest rates have heavily penalized small-cap companies. There’s no better way to see that than by looking at their performance since the start of 2024.
Here we can see the S&P 500 (SPY, orange) is up nearly 9% while the Small Cap S&P 600 (IJR, black) is slightly negative:
It comes down to cash. Cash-rich mega-cap companies like Apple (AAPL), Meta Platforms (META), and others are in a great position now, as they’re able to easily invest in growth and get a good yield on whatever cash is left idle.
Small-cap stocks, on the other hand, lack the cash to invest – and they have to borrow it at decades-high rates.
Corporate giants have pushed large-cap indices like the NASDAQ and S&P 500 to all-time highs. A world with higher rates drives investors to chase these large behemoths.
However, too much momentum leads to exuberance. Valuations get extended. That’s what’s happening right now in large-cap stocks.
To show you what I mean, below lists the current forward next-12-months P/E for several market benchmarks relative to their 20-year average:
Large-caps are richly valued to say the least, with the S&P 500 trading at 20.99 times earnings vs. the 20-year average of 15.84. The NASDAQ sits at a lofty 27.54 times earnings vs. a 20-year average of 19.84. Even the equal-weight S&P 500 is above its long-term average.
Contrast this to the “cheap” S&P Small Cap 600 priced at a P/E of 14.15, just below the 20-year average of 14.4.
Clearly, there’s a lot of value to be found in oversold small-caps right now.
I don’t believe this window of opportunity will hang around forever. And ultimately in a few months, the value presented NOW will be gone.
Let me show you why.
Why Small-Caps Are Set to Soar from Here
One of the biggest lessons I learned on a Wall Street trading desk was to think ahead.
Don’t invest based on today, focus on what’s coming in the future.
After the Fed press conference on Wednesday, Chairman Jerome Powell effectively greenlit rate cuts later this year.
The dot plots show that the Fed expects three interest rate cuts in 2024… exactly in-line with Wall Street expectations. Professional investors like to be on the same page with Fed policy.
Couple this with the fact that there’s no recession in sight, and you should be feeling pretty upbeat about the economy and your portfolio.
But if you’re still second guessing if now’s a good time to invest in small caps, consider this…
I went back and found all the times the Fed cut interest rates when the economy wasn’t in a recession, and importantly, didn’t fall into one a year later.
Since mid-1995, I found six instances including the mid-cycle ‘90s and the Global Currency Crisis of 1998.
Here’s how small-caps performed from the first day of the rate cuts…
The S&P Small Cap 600:
- Jumped 4.8% a month later
- Flew 10.6% three months after
- Soared 19.3% 12 months later
Lower rates are a boon for less-capitalized companies. The cost of capital shrinks and margins expand, leading to fatter profits.
Based on this setup, with the Fed set to begin rate cuts later this summer, a 19.3% runup for small-caps will put the S&P Small Cap 600 well north of its all-time high of 1470 back in November 2021.
We also can’t forget that this is an election year. As we showed in our election year playbook earlier this year, small-caps tend to surge in the back half of the year.
Folks, the time is now to focus on what’s coming…
Easier Fed policy in the coming months is lining up with a historical uptrend in election years.
With all this in mind, we can’t assume small-caps will be in the penalty box for much longer. The time to start buying the best stocks in this beaten-down sector is now.
This is where the power of data shines. TradeSmith is geared to bringing you the best small-caps in position for this coming watershed moment.
The way to play big is to go small…
Regards,
Lucas Downey
Contributing editor, TradeSmith Daily