The recovery in fundamentals for small-cap companies could take “longer to materialize following the Q2 reporting season,” analysts at brokerage firm Strategas said Wednesday.
They note that through the end of the first quarter, expectations for earnings per share (EPS) growth in small caps are expected to lag behind large caps, making it difficult to be overly optimistic about the outlook.
Strategas suggests that if the drawdown in small caps following the first Fed rate cut is less severe than in large caps, it "may make sense to begin adding exposure," but overall, it's challenging to take a fundamentally constructive stance on these stocks.
Historically, small-cap stocks underperform large caps by about 400 basis points as the business cycle peaks and begins to contract. This trend is driven by large-cap companies' easier access to capital and stronger cash flows compared to small caps, analysts explain.
The current environment might exacerbate that disparity, as approximately 40% of the Russell 2000 hasn't turned a profit in the past 12 months.
Despite this, historical data shows that small caps have outperformed large caps in all six recessions since 1980. On average, small caps outperformed large caps by 1,400 basis points on a forward 12-month basis from the recession's trough, as designated by the NBER.
“The difficulty here is that the 'end' of a recession is only clear in hindsight, but the story still stands that small cap stocks are typically more levered to fluctuations in the U.S. economic cycle’s rate-of-change than large cap stocks,” analysts at Strategas note.
July was a strong month for small caps relative to large caps, but concerns were raised earlier in the month due to the lack of participation from high relative low-beta stocks. As a result, more than two-thirds of the relative outperformance has reversed, with small caps struggling to keep pace during August's market sell-off.
“Until durable fundamental improvements form, we’d refrain from putting capital to work in the asset class at the expense of large cap exposure,” the firm concludes.