In an era of financial markets monopolized by trillion-dollar tech stocks, it can be easy to forget the small-cap space even exists.
But it’s still there, waiting for the moment when the infatuation with immensity eases, and the favour of the market shifts back to the little guy.
In recent weeks, several big-name market commentators have argued that that moment is already upon us.
It would be a good thing if they were right. Small-cap resurgences don’t only reflect growing economic confidence. They also make for healthier and more sustainable stock markets, by spreading returns across a wider variety of names.
But the timing of such turning points is highly uncertain. Much has to fall into place on the macro front.
“Everybody wants this to work,” said Mike Archibald, a vice-president and portfolio manager at AGF Investments Inc. who specializes in Canadian growth stocks.
“But for small caps to outperform, you need the economy to be resilient, and you need interest rates to come down meaningfully.”
Those are two big ifs. On both counts, however, the past month has given investors reasons to hope.
U.S. data on consumer prices for October showed core inflation, which excludes the volatile food and energy sectors, had slowed to an annualized pace of 2.4 per cent – tantalizingly close to the Federal Reserve’s target of 2 per cent.
The U.S. economy, meanwhile, continues to defy the recession that was widely expected to have arrived by now, with real GDP growth of 4.9 per cent annualized in the third quarter.
Canada’s economy isn’t quite so vigorous, but housing starts and employment readings point to continued resilience in the face of aggressive interest rate hikes.
All of that good news has some strategists pounding the table on small caps.
Canadian dollar notches 8-week high as soft landing hopes rise
In a note to clients, Richard Bernstein, the founder of RB Advisors and a former chief investment strategist at Merrill Lynch, called this moment a “once-in-a-generation opportunity to invest in this broad and ignored group.”
Here’s James Hodgins, an analyst at Stifel Nicolaus Canada: “After underperforming for the better part of the last decade, Canadian small-cap equities are literally begging to be bought.”
JP Morgan: “Small caps could lead the charge as we embark on the next bull run.”
Several analysts have pointed to the yawning gap in valuations between small and large-cap stocks. Lori Calvasina, head of U.S. equity strategy for RBC Dominion Securities, said “small caps are the cheapest we’ve seen since the dot-com era.”
And Schroders pointed out that shares in smaller U.S. companies now trade at valuations similar to those of stocks outside the U.S. – “offering investors a route into the U.S. economy without paying a premium.”
The last time U.S. small caps were this beaten down, it proved to be the starting point for a great revival in small-cap stocks.
In the seven-year period after the March, 2000, market peak, U.S. small-cap stocks outpaced their large-cap counterparts by seven to one, Schroders said.
The story was similar in the Canadian market in the aftermath of the dot-com bubble bursting. The S&P/TSX Composite Index gained just 6 per cent in the six years after peaking, while the S&P/TSX SmallCap Index rose by 40 per cent.
It has been mostly downhill since then. The commodity boom that sustained Canada’s resource sectors eventually faded away, and the entire Canadian small-cap ecosystem hollowed out.
International investors lost interest in Canada’s abundant mining and energy listings, as preferences shifted heavily toward large-cap stocks.
Moments when the small-cap space shines tend to come about when interest rates and bond yields are declining, and the broader economy is on the rise. A soft landing for the economy could be right in the small-cap sweet spot.
But investors have nothing resembling clarity on what the global economy will hold in 2024. And considering that the S&P/TSX SmallCap Index is more than 50 per cent weighted to resources, it is an extremely economically sensitive pocket of the market.
“Small caps in Canada can only outperform if resources do well,” Mr. Archibald said. “Otherwise, large caps will probably continue to get the money flow.”