Large-cap stocks have outperformed small-caps for more than a decade. At this point in the cycle, we believe small-cap valuations are quite attractive relative to large-caps. Heading into 2024, we think it may be time for investors to consider increasing their small-cap allocations.
Large-Caps Have Had a Long Run Outperforming Small-Caps
Large- and small-cap stocks can go through long cycles of outperforming one another. Large-caps’ current run of outperformance has stretched more than a decade. The following chart, provided with data from Furey Research Partners, shows some of the dominant periods of both market-cap segments and the level of outperformance by small- or large-caps.
The Large-Cap Cycle Has Made Small-Cap Valuations Quite Attractive on a Relative Basis
One way to assess the attractiveness of small-cap stocks is to compare their valuations to those of large-caps. Based on that relative comparison, our view is that small-caps haven’t been this attractive in more than 20 years. The following chart shows how the valuations of the two market-cap segments have compared over time.
In Prior Periods, Attractive Relative Valuations for Small-Caps Led to Stronger Relative Returns
At Wasatch, we don’t specialize in market forecasts and aren’t making a prediction of exactly when a large-cap cycle will end and a new small-cap cycle will begin. However, we think it’s worth noting that small-caps experienced outsized performance over large-caps at previous points when relative valuations were attractive. The following chart shows the 3-, 5- and 10-year outperformance of small-caps over large-caps, on an annualized basis, coming out of prior small-cap relative-valuation troughs over the last 50 years.
We Believe Wasatch Portfolios Are Positioned to Benefit When the Cycle Changes
Since early 2022, we’ve noticed an unusual dislocation between stock-price movements of our companies on one hand, and companies’ revenue growth and earnings growth on the other. Over longer periods, stock prices have tended to track revenue and earnings growth. But we believe the corporate operating performance that’s recently been “captured” in our small-cap strategies isn’t being properly reflected in recent stock returns.
The following chart shows the cumulative “capture” of quarterly revenue growth and earnings growth for all companies held in the Wasatch Small Cap Core Growth strategy over the last five years. While cumulative stock returns have periodically deviated from the trend in “captured” growth, they’ve generally come back into rough alignment. Based on our experience, this gap between stock returns and “captured” revenues and earnings should eventually close—with performance hopefully accruing in our favor.
Investors Can’t Time Cycles, But It May Be a Good Time to Review Small-Cap Allocations
No one can time a market cycle with certainty. But given the recent long period of large-cap outperformance and small-cap stocks’ attractive valuations relative to large-caps, we believe investors may want to review their small-cap allocations. Historically, investors have benefited from having a desired small-cap allocation in place before small-cap stocks rally. The following chart puts this in perspective. It shows the average one-year forward returns from the last 12 bear-market bottoms and what those returns were if investors missed the early days of the rally.
RISKS AND DISCLOSURES
Information in this document regarding market or economic trends, or the factors influencing historical or future performance, reflects the opinions of management as of the date of this document. These statements should not be relied upon for any other purpose. Past performance is no guarantee of future results, and there is no guarantee that the market forecasts discussed will be realized.
The Russell 1000 Index is an unmanaged total return index of the largest 1,000 companies in the Russell 3000 Index. The Russell 1000 typically comprises about 92% of the total market capitalization of all listed stocks in the U.S. equity market. It is considered a bellwether index for the performance of large company stocks.
The Russell 2000 Index is an unmanaged total return index of the smallest 2,000 companies in the Russell 3000 Index, as ranked by total market capitalization. The Russell 2000 is widely used in the industry to measure the performance of small company stocks.
The S&P 500 Index includes 500 of the United States’ largest stocks from a broad variety of industries. The Index is unmanaged and is a commonly used measure of common stock total return performance.
The CRSP 6-8 Decile Index is a small-cap index created and maintained by the Center for Research in Security Prices (CRSP) at the University of Chicago’s Graduate School of Business. CRSP capitalization-based indexes include common stocks listed on the NYSE, AMEX, and the NASDAQ National Market.
Indexes are unmanaged. Investors cannot invest in these or any indexes.
The Wasatch strategies have been developed solely by Wasatch Global Investors. The Wasatch strategies are not in any way connected to or sponsored, endorsed, sold or promoted by the London Stock Exchange Group PLC and its group undertakings (collectively, the “LSE Group”). FTSE Russell is a trading name of certain of the LSE Group companies.
All rights in the Russell Indexes vest in the relevant LSE Group company, which owns the Index. Russell ® is a trademark of the relevant LSE Group company and is used by any other LSE Group company under license.
These Indexes are calculated by or on behalf of FTSE International Limited or its affiliate, agent or partner. The LSE Group does not accept any liability whatsoever to any person arising out of (a) the use of, reliance on or any error in the Index or (b) investment in or operation of the Wasatch strategies or the suitability of the Index for the purpose to which it is being put by Wasatch Global Investors.
Wasatch Advisors LP, trading as Wasatch Global Investors, ARBN 605 031 909 is regulated by the U.S. Securities and Exchange Commission under U.S. laws which differ from Australian laws. Wasatch Global Investors is exempt from the requirement to hold an Australian financial services licence in accordance with class order 03/1100 in respect of the provision of financial services to wholesale clients in Australia. Wasatch Advisors LP, doing business as Wasatch Global Investors, is the investment advisor to Wasatch Funds.