Why Small Caps Lagged Earlier in 2024—and Pulled Back More in April

Equity markets have experienced downside volatility in April, following the strong rally that started last October and continued through the first quarter. In looking more closely at trends across sectors, sizes, and styles, investors may have noticed that small-cap stocks have struggled to gain footing, particularly when compared to large-caps and especially when compared to large-cap growth stocks. Since the bottom of the pandemic bear market in March 2020 through the end of Q1 2024, for instance, small-cap growth stocks are up 101.2%, while large-cap growth stocks are up 165.8%.

This performance gap seems to be persisting more recently. The Russell 2000 Index (small caps) rose 5.2% in the first quarter compared to the S&P 500’s 10.6% gain, and small caps have also fallen more during April’s pullback. As I write, the Russell 2000 Index is down around -8% for the month, compared to the S&P 500’s -5% decline. One might expect outperforming stocks to shed more on the downside, but that hasn’t been the case with small caps vs. large caps.(1)

So, what’s holding small caps back in the current environment? In a word, the Fed. As many readers know, the Federal Reserve has dialed back expectations for rate cuts in 2024, with the market now expecting less than two rate cuts in 2024—down from six to start the year. The return to the ‘higher for longer’ interest rate policy arguably hurts small-cap stocks more than it does large-caps. Big companies with healthy balance sheets have easy access to bond markets, and many took advantage of the era of low rates to lock in debt at attractive rates. Many large-cap companies are also flush with cash.

It tends to be the opposite for small caps. Small companies do not have the same easy access to bond markets, and many often don’t sit on piles of cash as they’re often too focused on investing and growing. This setup tends to translate into many small-caps borrowing at floating versus fixed rates, meaning that a period of rising interest rates can substantially raise costs. Consider that about 30% of debt held by Russell 2000 companies is floating, versus about 6% for S&P 500 companies.

Investors are less optimistic that the borrowing environment will improve substantially in 2024 for small caps, and that’s created some selling pressure. This is perhaps most evident when comparing changes in the Russell 2000 Index to changes in the 10-year U.S. Treasury bond yield. Generally speaking, as yields go up, small-cap stocks have gone down.

Does this mean the outlook for small-cap stocks is decisively negative for 2024? I think not. In my view, the Fed’s recent shift doesn’t change the notion that this interest rate cycle has peaked. With fed funds currently in a range between 5.25% and 5.5% and CPI at 3.8% (and the Fed’s preferred PCE price index at 2.5%) policy is already quite restrictive. Even a slight bump higher in inflation from here would not necessarily mean rate hikes and cuts are very much still on the table. If the U.S. economy is strong and the outlook is that rates will be lower in the future than they are today, that’s a constructive setup for small-cap stocks.?

Finally, there’s the matter of valuations. Because large-cap growth stocks have had an impressive run especially relative to small-cap stocks, there’s a valuation gap that makes small-cap stocks look inexpensive on a relative basis. As of the end of Q1 2024, for instance, small-cap value stocks were trading at 103% of their 20-year average P/E, while large-cap growth stocks were trading at 147% of 20-year P/E averages. If rate cuts do come and the U.S. economy continues to surprise to the upside, small-caps could easily lead again. ?

Bottom Line for Investors

Zooming out from the discussion of small-caps, I think it is important for investors to take a moment to think about recent downside volatility and what it means for investment strategies looking ahead.

The key thing to remember, in my view, is that even though the financial media will toil over assigning attribution to downside market volatility, the reality is that short-term pullbacks can happen for any number of reasons. They are an intrinsic part of equity investing. Since 1980, the average intra-year decline for the S&P 500 is -14.3%, which tells us that downside volatility is not an anomaly of equity investing—it’s a feature. During the eleven-year bull market that lasted from 2009 to 2020, there were a total of nine corrections. Pullbacks are normal.

The issue that often troubles many investors – and ultimately hurts them – is that they let volatility increase their temptation to “time the market,” allowing short-term uncertainties to drive their decision-making. Don’t fall into this trap.?

1 Wall Street Journal. April 21, 2024. https://www.wsj.com/finance/stocks/big-stocks-won-when-markets-rose-they-are-winning-again-in-the-selloff-39c66958?reflink=mobilewebshare_permalink

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.