Don't Swing to Small Stocks for the Wrong Reasons

Post-election “animal spirits” continue, with risk assets persisting in rally mode. As I wrote in a recent column, one area of heightened interest for investors has been small-cap stocks. The Russell 2000 Index posted its best single-day gain in almost two years following the election, as investors positioned for accelerating growth (via tax cuts and deregulation) combined with potential policies (tariffs) that favor companies with high relative levels of domestic production and revenue, i.e., small caps.(1)

Small-cap value has been the biggest beneficiary of these ‘themes’ in the weeks since the election, outperforming mid-cap and large-cap stocks across the value and growth spectrum. The trade is logical on its face—small-cap value stocks derive about 80% of their revenues domestically.?

The tax cut, deregulation, and tariff themes may play out just as investors are anticipating they will. But the decision to crowd into the small-cap trade—or significantly increase your allocation to small-caps now—would mean making assumptions about what future policy will look like, and how those policies will impact the economy. In other words, the allocation decision would be driven by changes to sentiment, not changes to economic fundamentals. That’s why I caution jumping into small-cap value stocks for the wrong reasons.

To be sure, history shows that high-quality small-cap stocks have delivered competitive returns relative to the broad stock market over long stretches of time, in many cases outperforming. Small-cap stocks also give investors exposure to companies with strong prospects for long-term earnings growth, while reaping potential benefits of broader portfolio diversification—helping to drive strong, long-term risk-adjusted returns. These would be among the reasons to have an allocation to small-cap stocks, which is very different from political and/or sentiment drivers.

History tells us that the short-term, sentiment-driven small-cap trade has not panned out so well.

In November and December 2016, after President Trump had won that election, small-cap stocks rallied strongly—for many of the same reasons we’re seeing today. The trade then was referred to as the “Trump Bump,” which was based on expectations for tax cuts, deregulation, infrastructure spending, protectionism, and higher growth rates. But by 2017, the trade had fizzled, and small-cap value was the worst-performing size/style category that year.

We saw a similar pattern in 2020. After President Biden’s victory, there was rising enthusiasm for the “reopening trade,” and small-cap value stocks delivered a powerful run-up. Since value stocks, in general, underperformed in the pandemic period, it was thought that a surge in economic vitality would revive investor enthusiasm for this attractive valuation category. This trade did well for a couple of years, but then the artificial intelligence effect on mega-cap technology stocks and large growth stole the show.

Though President-elect Trump has laid out an economic policy agenda that would arguably benefit small-cap stocks, much remains to be known. For instance, which of the policies will actually get enacted, and to what degree will they be altered or watered down? Will some policy ideas—like infrastructure in 2016—not get passed at all? Time will tell, but I think the overarching takeaway should be the same as it has been in previous election cycles. That is, if you’re going to invest in small-cap stocks, do so because you’re seeking to diversify your portfolio into an asset class with attractive long-term risk/reward profile—not because you think small-caps are poised to dominate in the next year.

Bottom Line for Investors

As I’ve written many times before, I firmly believe that fundamentals like earnings, cash flows, and valuations will drive markets far more over the long term than politics and policy. After all, elections happen every four years, and business and economic cycles basically never fit neatly into these four-year boxes.

That being said, we have a constructive outlook on the earnings picture for U.S. companies, and high-quality small-cap stocks trade at a discount to their large-cap peers—even though many of them have similar profit margins and free cash flows. For long-term growth-oriented portfolios, that makes a good argument for having a small-cap allocation for longer than just the next four years.?

1 Morningstar. November 17, 2024. https://www.morningstar.com/markets/this-unloved-asset-class-looks-attractive-regardless-election-results

DISCLOSURE ?

Past performance is no guarantee of future results. Inherent in any investment is the potential for loss.

Zacks Investment Management, Inc. is a wholly-owned subsidiary of Zacks Investment Research. Zacks Investment Management is an independent Registered Investment Advisory firm and acts as an investment manager for individuals and institutions. Zacks Investment Research is a provider of earnings data and other financial data to institutions and to individuals. ? This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. Do not act or rely upon the information and advice given in this publication without seeking the services of competent and professional legal, tax, or accounting counsel. Publication and distribution of this article is not intended to create, and the information contained herein does not constitute, an attorney-client relationship. No recommendation or advice is being given as to whether any investment or strategy is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of herein and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole. ? Any projections, targets, or estimates in this report are forward looking statements and are based on the firm’s research, analysis, and assumptions. Due to rapidly changing market conditions and the complexity of investment decisions, supplemental information and other sources may be required to make informed investment decisions based on your individual investment objectives and suitability specifications. All expressions of opinions are subject to change without notice. Clients should seek financial advice regarding the appropriateness of investing in any security or investment strategy discussed in this presentation. ? Certain economic and market information contained herein has been obtained from published sources prepared by other parties.? Zacks Investment Management does not assume any responsibility for the accuracy or completeness of such information. Further, no third party has assumed responsibility for independently verifying the information contained herein and accordingly no such persons make any representations with respect to the accuracy, completeness or reasonableness of the information provided herein. Unless otherwise indicated, market analysis and conclusions are based upon opinions or assumptions that Zacks Investment Management considers to be reasonable. Any investment inherently involves a high degree of risk, beyond any specific risks discussed herein.

The S&P 500 Index is a well-known, unmanaged index of the prices of 500 large-company common stocks, mainly blue-chip stocks, selected by Standard & Poor’s. The S&P 500 Index assumes reinvestment of dividends but does not reflect advisory fees. The volatility of the benchmark may be materially different from the individual performance obtained by a specific investor. An investor cannot invest directly in an index.?

The Russell 1000 Growth Index is a well-known, unmanaged index of the prices of 1000 large-company growth common stocks selected by Russell. The Russell 1000 Growth Index assumes reinvestment of dividends but does not reflect advisory fees. An investor cannot invest directly in an index. The volatility of the benchmark may be materially different from the individual performance obtained by a specific investor.

Nasdaq Composite Index is the market capitalization-weighted index of over 3,300 common equities listed on the Nasdaq stock exchange. The types of securities in the index include American depositary receipts, common stocks, real estate investment trusts (REITs) and tracking stocks, as well as limited partnership interests. The index includes all Nasdaq-listed stocks that are not derivatives, preferred shares, funds, exchange-traded funds (ETFs) or debenture securities. An investor cannot invest directly in an index. The volatility of the benchmark may be materially different from the individual performance obtained by a specific investor.

The Dow Jones Industrial Average measures the daily stock market movements of 30 U.S. publicly-traded companies listed on the NASDAQ or the New York Stock Exchange (NYSE). The 30 publicly-owned companies are considered leaders in the United States economy. An investor cannot directly invest in an index.? The volatility of the benchmark may be materially different from the individual performance obtained by a specific investor.

The Bloomberg Global Aggregate Index is a flagship measure of global investment grade debt from twenty-four local currency markets. This multi-currency benchmark includes treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging markets issuers. An investor cannot invest directly in an index. The volatility of the benchmark may be materially different from the individual performance obtained by a specific investor.

The ICE Exchange-Listed Fixed & Adjustable Rate Preferred Securities Index is a modified market capitalization weighted index composed of preferred stock and securities that are functionally equivalent to preferred stock including, but not limited to, depositary preferred securities, perpetual subordinated debt and certain securities issued by banks and other financial institutions that are eligible for capital treatment with respect to such instruments akin to that received for issuance of straight preferred stock. An investor cannot invest directly in an index. The volatility of the benchmark may be materially different from the individual performance obtained by a specific investor.

The MSCI ACWI ex U.S. Index captures large and mid-cap representation across 22 of 23 Developed Markets (DM) countries (excluding the United States) and 24 Emerging Markets (EM) countries. The index covers approximately 85% of the global equity opportunity set outside the U.S. An investor cannot invest directly in an index. The volatility of the benchmark may be materially different from the individual performance obtained by a specific investor.

The Russell 2000 Index is a well-known, unmanaged index of the prices of 2000 small-cap company common stocks, selected by Russell. The Russell 2000 Index assumes reinvestment of dividends but does not reflect advisory fees. An investor cannot invest directly in an index. The volatility of the benchmark may be materially different from the individual performance obtained by a specific investor.

The S&P Mid Cap 400 provides investors with a benchmark for mid-sized companies. The index, which is distinct from the large-cap S&P 500, is designed to measure the performance of 400 mid-sized companies, reflecting the distinctive risk and return characteristics of this market segment.

The S&P 500 Pure Value index is a style-concentrated index designed to track the performance of stocks that exhibit the strongest value characteristics by using a style-attractiveness-weighting scheme. An investor cannot directly invest in an index.? The volatility of the benchmark may be materially different from the individual performance obtained by a specific investor.

The CBOE Volatility Index (VIX) is a calculation designed to produce a measure of constant, 30-day expected volatility of the U.S. stock market, derived from real-time, mid-quote prices of S&P 500 Index call and put options. On a global basis, it is one of the most recognized measures of volatility -- widely reported by financial media and closely followed by a variety of market participants as a daily market indicator. The volatility of the benchmark may be materially different from the individual performance obtained by a specific investor. An investor cannot invest directly in an index.

The Nikkei Stock Average, the Nikkei 225 is used around the globe as the premier index of Japanese stocks. More than 60 years have passed since the commencement of its calculation, which represents the history of Japanese economy after the World War II. Because of the prominent nature of the index, many financial products linked to the Nikkei 225 have been created are traded worldwide while the index has been sufficiently used as the indicator of the movement of Japanese stock markets. The Nikkei 225 is a price-weighted equity index, which consists of 225 stocks in the 1st section of the Tokyo Stock Exchange. The volatility of the benchmark may be materially different from the individual performance obtained by a specific investor.

The MSCI World Index captures large and mid-cap representation across 23 Developed Markets (DM) countries. The index covers approximately 85% of the free float-adjusted market capitalization in each country.?The volatility of the benchmark may be materially different from the individual performance obtained by a specific investor.