Small Cap Rally Has Started – Maybe it never stopped

By David Nelson, CFA CMT

After years of taking a back seat to large cap secular growth small caps have suddenly exploded higher catching the eye of investors. Caught off guard hiding in the safety of large companies with bigger and stronger balance sheets professional and retail investors are being forced to rethink portfolio alignment and make room for this forgotten asset class. The chart below begs the question does the rally have legs in an uncertain world and do the fundamentals support the price action.

A near decade of underperformance on the heels of the financial crisis and the quantitative easing that followed have pushed investors to concentrate capital into a handful of names. $500 Billion market caps once the pinnacle are now dwarfed by $Trillion-dollar stocks like Apple (AAPL), Microsoft (MSFT), Amazon (AMZN) and Alphabet (GOOGL). (Apple is over $2 Trillion)

The truth is for most of the last 20 years small caps have kept pace or outperformed large caps. However, with one decision stocks like the above dominating both the indices and investor portfolios small caps seemed to fall out of favor.

It’s not the first time one decision stocks i.e., just buy and never sell have dominated the landscape. In the late 60’s and early 70’s The Nifty 50 were the FANG stocks of their generation. Many of those names are still with us like McDonalds, Philip Morris and IBM but have a fraction of influence they had during those years. The market caps speak for themselves.

Nifty 50 Stocks

Price momentum always attracts investor interest and quarter to date you’d have to be living under rock not to notice that IWM and MDY are outperforming SPY by a factor of 2. Even the equal weight counterpart, RSP has beaten the market cap weighted ETF SPY this quarter. Let’s dig down and see what’s driving the price action.

The relative valuation is certainly compelling especially with the S&P now pushing 22x earnings for next year. The Russell is almost 8 handles lower at just over 14x. That’s attractive but I can make the case that large caps with a perceived safety net deserve a premium especially in the face of so much uncertainty.

For me the holy grail of quant factor investing is estimate revision. On the heels of a several vaccine candidates close to launch it’s not surprising analysts are tripping over themselves to raise estimates on their coverage. This of course gets captured in the consensus estimates for the various indices where we can dig down and see if there is something driving the recent surge in small cap momentum.

S&P 500 Earning’s Growth 2021 & 2022

Coming off easy comparisons and rising estimate revisions over the last couple of months S&P 500 earnings look to grow next year and the year after 21% and 16% respectively.  S&P 600 Small Cap Index shows estimates for 2021 up a staggering 58% over this year. Estimates for the Russell 2000 ETF IWM are almost double that growth but without access to the drill down detail I’m reluctant to print a number. Earnings growth for many companies outside the Mega Cap arena will dwarf some long-time investor favorites.

S&P 600 Small Cap Earnings Growth 2021 & 2022

Apple the world’s largest company looks to grow earnings at about 18% year on year and just 9% the year after. Earnings growth for Microsoft (MSFT) is expected to be just 13%.
It’s not just stock analysts raising estimates but economists as well. The Atlanta Fed has just upped their estimate for 4th quarter GDP to over 11% and that’s with COVID currently raging across America challenging hospital capacity. Goldman puts global growth next year at about 6% and current consensus for the US is now 4% or possibly higher.

Growth is the most expensive when there isn’t any. Suddenly there is a wide range of choices available outside large cap secular growth. FANG is rapidly becoming the defensive play. The risk on team has a lot of new faces.

It makes perfect sense for investors to move down the valuation curve to other parts of our economy poised to grow their way out of a pandemic induced coma. Small and mid-cap stocks are clearly part of the playbook.

*At the time of this article some funds managed by David were long AAPL, MSFT, AMZN, GOOGL, SPY & RSP