But where are we in the cycle today? While growth was never low enough to produce a technical recession in the current cycle, surging growth in late 2023 could indicate that the economy bottomed in the third quarter. But it is more likely that the U.S. economy hasn’t bottomed yet. This is in line with our view (and the majority of market forecasters) that the economy will continue to slow in 2024 but have a soft landing, rebounding late in the year or next year. However, forecasting the pace of economic growth is difficult and forecasting turning points in the economy is even more difficult. A majority of economists, for example, predicted a recession in 2023, and yet it never materialized.

Standard valuation metrics may help, but here too the devil is in the details. As of January 2024, the Russell 2000 Index is enduring its longest drawdown (languishing below a previous high) in the index’s history. While one could argue that small-caps are thus due a period of outperformance, one could have plausibly argued this at many points in recent years, pointing to lagging performance, positive technical factors and attractive valuations. 

The 2024 outlook for small-caps is promising

There are both fundamental and technical reasons to be optimistic about the small-cap market this year. The foremost is the likelihood of an economic recovery and the boost that may provide small-cap earnings. Corporate profits broadly have already bottomed, and they are currently accelerating for many large-cap companies. History tells us that periods of improving earnings-per-share growth—even if the economy is still slowing—disproportionally benefit small-cap companies.

While this argument may assume improving—even bottoming—economic growth should lead to a wider range of companies seeing competitive returns, this does not strike us an unreasonable assumption. 2023 saw the narrowest dispersion of returns since the 1980s. Only 27% of companies on the S&P 500^® Index outperformed the index last year, and just (a magnificent) seven of these were responsible for 30% of its 2023 return. While the strength and speed of a recovery is unclear, we remain optimistic that small-cap earnings could catch up to the broader market by the end of 2024 as the economy recovers and the dispersion of returns broadens.

Finally, assuming inflation does not reverse its current trend, the U.S. Federal Reserve (Fed) should lower interest rates in 2024, also disproportionately benefiting small-cap companies. Broadly speaking, small-cap companies tend to hold more debt than larger ones, making their profits more sensitive to the cost of servicing this debt. Lower interest rates will help. Additionally, small-cap companies typically hold more floating rate debt as they have more bank funding than larger companies that favor financing in the corporate bond market. Given that U.S. floating rate interest is ultimately tied to the Fed’s monetary policy rate, any cuts to this rate would have an immediate impact.

Turning to more technical factors, a small improvement in sentiment toward small-cap stocks could have a large (and potentially rapid) impact on returns. Because the asset class has languished in recent years (and the economy was thought to enter a recession last year), many strategic investors may be underinvested, as can be seen in the chart below. It is possible that a virtuous circle of improving sentiment could lead to increased inflows to the asset class—boosting returns—further boosting sentiment.

Meanwhile, current small-cap price/earnings (P/E) ratios are about 25% below their average relative to large-cap P/E ratios—an extreme level not seen since the dot-com euphoria days about 20 years ago. On a price basis, the gap between the Russell 2000 Index and the Russell 1000 Index is near two standard deviations below its average. Simply put, a variety of valuation measures suggest small-cap stocks are the cheapest they have been since 2007. 

The argument for strategic exposure to small-caps

The chart below shows that over the past 30 years small-cap stocks significantly outperformed large-cap stocks. While the exact amount will vary according to the time period chosen (and in recent years it has been consistently negative) there are compelling arguments for long-term strategic allocations to the asset class.

First, small-cap stocks are generally more volatile than large-cap stocks. This can be seen in the chart above by comparing the sharp rises and swift plunges of the tan (small-cap) line relative to the more stable black (large-cap) line. While volatility may intuitively be a bad thing, it typically comes with a corresponding return premium to compensate investors for taking additional short-term price risk. For long-term strategic investors less sensitive to short-term volatility, any additional premium offered could be seen as an attractive asset.

The chart above also highlights just how quickly periods of small-cap strength can materialize. In the 2020-2021 spike visible above, when global investors began to price in a COVID-19 vaccine, small-cap stocks outperformed large-caps by around 40% in less than six months. To the extent there are reasons to be optimistic about the short-term (one-year) performance of small-caps, and the market is difficult to time, investors may be better served simply holding an appropriate amount of the asset class for their individual risk and return targets.

There are also larger economic trends that could disproportionately boost small-cap stocks in the years ahead. For example, there are compelling arguments that technological advances like cloud computing and artificial intelligence are helping to level the playing field between small and large companies, allowing smaller companies many of the advantages that only their larger competitors had enjoyed. More generally, the U.S. economy is increasingly reliant on technology, the country is the world’s leading technological innovator. Small-cap investors may be rewarded for patient, long-term allocations.