Small-cap stocks are seeing significant price-to-earnings (P/E) multiple expansion, driven by post-election optimism and expectations of deregulation and growth, according to a report from Bank of America. However, the sector's earnings continue to lag, keeping it in what the bank describes as a "profits recession."
The Russell 2000’s forward 12-month P/E ratio climbed 10% in November to 17.0x—its highest level in 3.5 years and 12% above the historical average. Despite this, the index's year-to-date (YTD) returns have been almost entirely due to valuation expansion rather than earnings growth, which remains under pressure.
Bank of America notes that small caps are relatively cheaper than large caps, which trade at over 40% above their historical average P/E. Yet, risks loom for small-cap earnings, particularly from potential headwinds tied to policies such as tariffs and immigration reforms.
Financials emerged as the top-performing sector in Bank of America’s small-cap tactical quant framework, benefiting from optimism around deregulation and tax cuts. On the other hand, Communication Services ranked last, followed by Consumer Discretionary and Technology sectors.
While small caps currently face challenges in earnings growth, Bank of America projects better long-term returns for the Russell 2000 compared to the Russell 1000, supported by relatively lower valuations. Over the next decade, small caps are expected to deliver high-single-digit annualized price returns versus low-single-digit returns for large caps.
“Optimism is high for small caps, but the market has priced in significant growth expectations, leaving little room for error,” the report cautions.
Here's a look at some small cap companies making news this week.