Investors are buzzing with questions about small-cap stocks in the wake of a recent rally.
The consensus from analysts at Bank of America is that while there are several factors supporting continued outperformance, the sustainability of the rally hinges on forthcoming earnings results.
Analysts are generally optimistic about the long-term prospects for small-cap stocks.
“Positioning, technicals, relative valuations and the Fed backdrop are supportive for further leadership by the Russell 2000, and we have been positive on the long-term case for small vs. large caps,” analysts wrote.
But near-term, a pause in the rally is likely if there is no “fundamental support,” they cautioned.
“As such, we'd remain selective for now - we still see opportunities for outperformance from pockets of small caps (particularly Value stocks that have fundamental support (profitable/positive revisions)) and we'd continue to avoid highly levered stocks with refinancing risk until Fed cuts are certain. But we remain nimble.”
Here are the five most frequently asked questions according to Bank of America:
Are small caps still undervalued?
The answer is No. On an absolute basis, small caps are not cheap compared to their historical average, but they are cheaper relative to large caps.
Bank of America analysts note that the Russell 2000, which tracks small-cap stocks, is trading at a P/E ratio of 15.5x, slightly above its historical average of 15.2x, indicating it's not particularly cheap on an absolute basis.
However, small caps are about 25% cheaper relative to large caps compared to historical norms, with a relative P/E ratio of 0.74 versus a historical average of 1.0x. Excluding the influence of major tech stocks (the Magnificent 7), small caps are 17% more discounted relative to large caps than historically, underscoring their relative attractiveness.
Is there evidence of a recovery in earnings per share (EPS)?
According to Bank of America, small-cap stocks are seeing an expansion in their P/E ratios rather than improvements in earnings. EPS estimates for small caps, as represented by the S&P 600, have decreased by 1% month-to-date, while estimates for large caps have slightly increased.
Additionally, the second-quarter results for small caps are falling short of expectations for both EPS and sales. Only 17% of small caps have exceeded expectations in both areas, compared to 50% of large caps. Guidance for small caps also remains weak.
What factors have driven the recent performance?
Recent stock market gains have been driven by several factors, including short covering in high short interest stocks, strong performance in deep value stocks like those in the financial sector, and leveraged stocks benefiting from anticipated Federal Reserve interest rate cuts that reduce refinancing risks. Additionally, revisions in earnings estimates have highlighted a focus on fundamental factors.
What do current flows and technical indicators suggest?
Current data shows near-record inflows into small-cap funds, though historically, small-cap inflows have been smaller compared to large-cap inflows. Despite this, Bank of America's Client Flows report indicates that clients have sold small-cap stocks recently but bought small-cap ETFs.
Technical analysis does suggest strong support for a potential breakout in the Russell 2000 index, signaling positive technical prospects for small-cap stocks.
How do small caps outside the US compare?
Bank of America’s European analysts are overweight on small caps as a cyclical hedge, believing that these stocks have already factored in much of the expected macroeconomic weakness.
In contrast to the US, consensus EPS trends for small caps versus large caps in Europe have been improving. European small caps are currently considered cheap relative to both European large caps and US small caps.