Why bulls are betting on small-cap stocks to continue their winning ways

So far in 2018, the best way to get strong returns without corresponding volatility has come from small-cap stocks, which have outperformed their large-cap counterparts by a comfortable margin while avoiding big gyrations.

Hindsight is great, but should investors expect small cap outperformance to last? Sam Stovall, chief investment strategist at CFRA, a research firm, said that history suggests that small stocks indeed have more room for growth.

Indeed, the small-cap S&P 600 index
SML, +1.60%
as well as the Russell 2000
RUT, +1.67%
hit new all-time highs on Wednesday, seemingly impervious to the kind of geopolitical fear that sent the Dow industrials down nearly 400 points only a day before.

The S&P 600 is up 8.6% since the start of the year, compared with 2.6% gain for the large-cap S&P 500
SPX, +1.39%
as of Wednesday.

Also, the small-cap gains have been broad. According to Stovall, seven of 11 S&P SmallCap 600 sectors have posted positive returns since Jan. 26, when the S&P 500 peaked, and all have outpaced their large-cap counterparts.

In contrast, the S&P 500is still trading about 5% below its peak on Jan 26 with only the technology sector having recovered from the 10% drop.

So the pullback by small-caps earlier this year was smaller than in the S&P 500, while the recovery was faster.

This may come as a surprise to those who still think that small stocks are more volatile than large stocks. Stovall said that since the introduction of the Russell 2000 index in 1978, and the birth of the S&P SmallCap 600 in 1995, small-cap benchmarks have recorded fewer mega-meltdown bear markets and shallower average bear-market price declines than the S&P 500.

Looking deeper into history of pullback and recoveries, Stovall found that on average small-cap stocks took about a month to fall between 5%-10% and about a month to fully recover. History also showed that after a recovery, small-caps went on to rise more than 8%, on average, over the ensuing two months.

Stovall cautions that these are, of course, averages and while history may suggest the most likely scenario, it is never a guarantee.

The most recent episode of a pullback is playing out close to these historic patterns: the S&P 600 fell about 8.8% from Jan 26. through Feb. 8 and recorded a new all-time high on May 9. The small-cap index has gained 3.8% since then.

Read: Heres why small-cap stocks can continue to beat their large-cap peers

Considering that small-cap stocks traditionally rose more than 8% in price after the conclusion of a pullback, history suggests the S&P 600 possibly has another 5% to go before slipping into another decline of 5% or more, Stovall wrote.

Small-caps have fundamentals on their side as well. Earnings per share for the small-cap index are projected to grow by 31.3% in 2018 and 16.7% in 2019, according to Stovall.

That is compared with S&P 500 projected EPS growth of 20.6% in 2018 and 10.6% rise in 2019.

Given such strong metrics, the S&P 600 should be trading at a much higher valuations, Stovall said.

Leave a Reply

Your email address will not be published.