Will Small-Cap Stocks Ever Catch Up?

It’s the rally that just won’t seem to come.

By some measures, small company stocks have been due for a breakout for a very long time. They’re cheap, they’ve underperformed for years, and a healthy economy means they have plenty of room to grow. But so far, the smallest players in the market have yet to live up to that potential. Small-cap stocks have consistently lagged their larger counterparts, in recent times thanks to persistent high interest rates and insatiable investor appetite for high-flying mega-sized tech stocks.

In the first quarter, the Morningstar US Small Cap Index returned 5.7%—a little more than half of the 10.2% return of the total market. Meanwhile, the Morningstar US Large Cap Index returned 11.1%. Over the past five years, small caps have returned 48% versus 92% returns for the market more broadly. Despite this, strategists say there are good reasons to own this under-loved segment. Here’s what investors need to know.

Why Haven’t Small Caps Performed Well?

Investors often look to small caps for their growth potential, but that potential comes with a downside. Because they’re less likely to be profitable and more likely to need to borrow money to fund their operations, small-cap companies are much more sensitive to changes in interest rates than larger stocks. They also tend to be much more volatile.

“You’re taking on more risk because these companies are smaller and less established,” says Steve Sosnick, chief strategist at Interactive Brokers. “They typically do not have … bottom-line results that can be relied upon through thick and thin. That is often a real headwind for them, and unfortunately, this is one of those times.”

Changing Rate Expectations and AI Euphoria Keep Small Caps Down

A series of hot economic data prints earlier this year prompted markets to dramatically reduce their expectations around the timing and scope of interest rate cuts. Investors now expect fewer cuts starting later in 2024, and that “higher for longer” rate outlook hit small caps much harder than large caps, explains Kristy Akullian, head of iShares investment strategy, Americas, at BlackRock. “That’s what has kept their price contained.”

The artificial intelligence boom hasn’t helped the outlook for smaller companies either. “Generative AI … really took over the driver’s seat for one part of the equity market and left the rest behind,” Akullian says. While large-cap growth stocks soared on enthusiasm for artificial intelligence, defying concerns about high rates and frothy valuations, small caps “reacted in a much more historically rational way to what was happening in the broader economy,” she explains.

Market conditions suggest small-cap stocks will likely continue facing significant headwinds. The labor market remains robust and inflation remains sticky, meaning the central bank is unlikely to rush to cut interest rates. And despite their cheap price tag, small caps have been unable to compete with market giants like Nvidia NVDA and Microsoft MSFT, which continue to deliver powerful earnings growth even though they’re not trading at discounts.

“We haven’t seen a positive inflection higher in earnings, margins, and forecasted growth for small-cap companies as we have for some of the larger growth cohort,” Akullian says. That’s not to say they won’t ever break out. “They will certainly have their day,” she adds.

Do Small Caps Have Potential?

Denise Chisholm, director of quantitative market strategy at Fidelity Investments, points to three factors that she says create a “coiled spring” scenario for small caps: relatively cheap valuations on the whole, wide valuation spreads within the sector (which indicates investors are searching for quality), and the possibility that the Fed will indeed cut rates. “It doesn’t mean it has to come to fruition,” she says, “and it certainly hasn’t over the last six months. But the signals are all still there.”

Morningstar chief US market strategist Dave Sekera also sees potential for value stocks because of their cheap price tag and the likelihood of a soft landing for the economy. “Based on a combination of these valuations and our economic outlook, we see a good setup for both value stocks and small-cap stocks,” he writes.

A change in the interest rate environment will be the “primary catalyst” for a small-cap breakout, Chisholm adds, but lower rates on their own likely won’t be enough to spark a turnaround. “It has to be the conjunction of rates having peaked and earnings growth having troughed.” She says this scenario increases the sector’s outperformance odds by almost 50 percentage points.

Should You Invest In Small Caps?

While it’s impossible to ignore the consistent outperformance of the mega-cap tech sector, strategists say small caps still have a place in investors’ portfolios. “The trend is your friend … it’s impossible to fight it,” says Sosnick. “But you’ve got to start thinking about a little bit of defense, because these things don’t go on forever.”

Chisholm also points out that historically, small caps are more likely to outperform in bear markets than bull markets—another argument for diversification. Sosnick cautions, however, that a sector-wide bet on small caps via an index fund comes with challenges. For example, many small-cap companies are unprofitable, and the sector tends to be much more volatile than other areas. “There are always going to be the diamonds in the rough,” but it “takes a lot of work” to find them.

For Akullian, this is where a more active strategy comes in: “Maybe it’s less about static index allocations for things like small cap or value that haven’t performed quite as well, and [more about] being more nimble and more dynamic around it.” She says that could mean rotating in and out of index products or outsourcing to an active manager.