LGIM: What’s behind the rally in US small caps?

4 december 2024

US small caps have risen up the investment agenda in recent weeks following strong performance in the immediate aftermath of Donald Trump’s election. In this article, we outline the factors that may have contributed to positive sentiment around US small caps in the wake of the Republican victory, before considering the other reasons why multi-asset investors may want to consider an allocation to these assets.

We would point to three fundamental factors behind the recent rally. First, the US dollar has found support as investors price in the likelihood of tighter immigration controls, additional tariffs, and the prospect of easier fiscal policy via tax cuts. A more expensive US dollar is generally a headwind for companies that have more international exposure and sell goods abroad at more expensive prices – so a stronger dollar can be expected to weigh on expectations for large caps while providing a relatively more favourable environment for small caps.

Second, US companies with more domestic focus (meaning small caps) can be expected to benefit from protectionist policy making. In the small cap universe, 90% of revenues are American, compared with 60-65% for the large cap universe. (Source: Bloomberg as at 6 November 2024, Russell 2000 and S&P 500 index comparisons).

Finally, near- to medium-term monetary policy continues to provide an encouraging backdrop for US small caps. The Federal Reserve cut the federal funds target range by 25 basis points (bps) at its November meeting, building on September’s bumper inaugural 50bps cut. In general, lower interest rates, meaning lower borrowing costs for corporations, can be expected to benefit small caps more than large caps given their greater need for finance to fund expansion efforts.

Small-cap valuations in focus

Since 2018, the relative valuations of US small caps versus large caps have been below their 20-year average, which indicates that US small caps have become more undervalued relative to their large cap counterparties.

The chart below shows average monthly index-adjusted positive price-to-earnings (P/E) ratios. Approximately a fifth of the US small-cap universe by market cap has exposure to negative earnings, compared with a 10th for large caps. Hence using unadjusted P/Es is likely to result in spikes and outliers especially around times of high market volatility when earnings deteriorate.

Therefore, to make valuations more comparable, in our analysis we have only considered companies with positive trailing 12-month earnings. 

Diversification

We believe diversification provides a compelling argument for an allocation to US small caps as part of a multi-asset portfolio.

It’s no secret that the importance of the ‘magnificent seven’ – Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla – has risen to what might be considered uncomfortable levels in recent years, contributing more than half of the 25.7% rise of the S&P 500 last year. (Source: Bloomberg, as at end-2023) This year, Nvidia has emerged as the flagbearer of exuberance around artificial intelligence, leading to continued concentration of performance.

For investors seeking diversified exposure to the US equity market, there are compelling alternatives to the increasingly top-heavy S&P 500. In the S&P 500, the top 10 stocks account for 34% of total index weight, and the top 100 stocks account for 72% of total index weight. In the Russell 2000, by contrast, the top 10 stocks account for 3% of total index weight, and the top 100 stocks account for 22% of total index weight. (Source: Bloomberg, as at 14 November 2024)

Small-cap indices such as the Russell 2000 also offer greater diversification at the sector level, providing a counterbalance to the S&P 500’s heavy tilt towards the information technology sector, while adding exposure to underrepresented sectors such as industrials, energy, and materials. Additionally, there are differences within each sector between indices. For example, a large cap exposure would include large integrated companies, with high international revenue exposure, while small cap stocks such as those found in the Russell 2000 tend to be more diversified, specialised, and local. 

Why consider a quality overlay

For investors who want to tap the performance of the US small cap universe, as well as the longer-term potential benefit of increased diversification, we believe adding a quality factor overlay is worth consideration.

As we saw during early-2023, the consequences of a downturn in the economic climate can be amplified in small-cap companies. Compared with large, more established companies, small caps potentially suffer a greater impact on their profits and their shares can be subject to higher risk and volatility.

In such an environment, we believe adding a quality overlay that considers metrics such as return on assets and leverage to US small-cap exposure, without affecting the original sector allocation, could add resiliency to a portfolio.

Such an overlay can be helpful to increase exposure to companies that are potentially better placed to weather these difficulties and reduce exposure to those with poorer quality characteristics.

How the quality overlay has mitigated drawdowns over two decades

The chart below shows the effect of the quality overlay of the Russell 2000 Quality index versus the standard Russell 2000 index during periods of negative performance.

The Russell 2000 Quality index had a maximum drawdown of -57%, compared with -59% for the Russell 2000, and the number of days spent below a -5% drawdown was 55% for the Russell 2000 Quality index, compared with 59% for its factorneutral counterparty.

As you can see, the quality overlay has been consistently successful in mitigating periods of negative performance. Over the same period, the Russell 2000 Quality index has outperformed the Russell 2000 index, indicating that historically it has been possible to improve drawdown mitigation without sacrificing performance.