Small cap US stocks were the standout on Wednesday, with the Russell 2000 index surging 3% to 2,283, but analysts at Bank of America cautioned that investors should weigh both risks and long-term opportunities in the sector.
The Russell 2000, which tracks smaller companies, is trading near its long-term average valuation, while larger companies remain far more expensive, analysts noted.
Small caps are roughly 30% cheaper than their historical average relative to large caps, but the discount may not fully narrow due to higher debt levels, more volatile earnings, and fewer profitable companies than in the past.
Despite these challenges, secular trends such as US manufacturing investment, reshoring, and a decade of underperformance suggest small caps could outperform over the next 10 years, the analysts said.
Earnings for small-cap companies are showing signs of improvement. S&P 600 earnings are expected to turn positive in the second quarter following stronger-than-expected results, and analyst guidance has begun trending upward. However, small caps continue to trail larger companies in sales growth and corporate confidence.
Near-term headwinds include potential Federal Reserve moves, tariff risks, and ongoing weak fundamentals.
Medium-sized companies, or mid caps, appear more attractive in the near term. Analysts said mid caps have stronger fundamentals, cleaner balance sheets, and less exposure to tariffs.
Their valuations are the lowest relative to mega caps in more than 20 years, prompting BofA to favor mid caps over both small and large companies at present.
Microcaps, or very small companies, are considered overvalued. They have surged recently, trading at significantly higher multiples than historical averages, and only about 40% are expected to be profitable over the next year.
In terms of sectors, financials remain the top pick for both small and mid caps, supported by low valuations, positive earnings revisions, and better-than-expected second-quarter results from banks. Health care, materials, and small-cap energy sectors ranked poorly, the analysts noted.