Shaking off the underperformance of the past few years, small stocks are finally catching up with their larger counterparts.
Over the past month, they’ve outperformed large-cap stocks while continuing to trade at a relative discount based on forward-earnings multiples for the first time since 2003 as expectations for future earnings rise, according to analysts at Bank of America Merrill Lynch.
Thanks to an impressive 22% rally from the February lows, the Russell 2000 index
the most widely used benchmark for small stocks, is now up as much as the S&P 500
year to date—about 5.7%.
Read: ‘Inverted head-and-shoulders’ pattern in small-cap stocks sounds a bullish signal
Yet, while the S&P 500 overtook its previous all-time high last week, the Russell 2000 needs another 7% gain to match its own all-time high.
History shows that, on average, once the index scales new highs after recovering from a bear market, it gains another 6.7% in 57 calendar days before slipping into another decline of 5% or more, according to Sam Stovall, U.S. equity strategist at S&P Global Market Intelligence.
Stovall cautions, however, that “history is only a guide, never gospel.”
So, if small-caps can take out the old highs, they’ll potentially have two things going for them—historical performance suggesting solid gains after post-bear-market records and forward-earnings valuations that are cheaper than large-caps.
The momentum factor, following a 22% gain over five months, is also in the bull camp’s favor.
But analysts at Bank of America Merrill Lynch, despite agreeing with those assertions, continue to sound a cautious note when it comes to small-cap stocks.
First, they are skeptical about positive revisions to future earnings, which reduce the price-to-earnings ratio but tend to be unreliable and volatile.
According to BAML, the Russell 2000 12-month, forward price-to-earnings ratio is at 16.3 times, trading at a 3% discount to the Russell 1000 index of large stocks—and well below the average-historical premium of 5% seen since 1985.
“While the relative valuations suggest that small-cap returns may exceed large-cap returns over the long term, we think that before the end of this cycle, the small-cap underperformance gap will widen further,” the note said.
They are also wary about performance of risky assets when overall market volatility is low.
“Risk assets such as small-caps tend to be negatively correlated with volatility, which has fallen back near a 12-month low, but we expect volatility to pick up again in the coming months, driven by a pullback in oil prices, deteriorating credit trends, choppy macro data and what is likely to be a heated election season,” read the research note published on July 19.
The implied volatility of the S&P 500, as measured by the CBOE Volatility Index
also known as “Wall Street’s fear gauge,” has fallen 19% to 12.65, its lowest level in a year.
Small-cap stocks might seem relatively inexpensive compared with large-cap stocks, but in absolute terms, they are trading at a double-digit premium to their historical average since 1985, according to BAML.
BAML analysts are also concerned about excessive leverage, which in the past year has been driven by the collapse in energy earnings.
“However, even excluding energy, small-cap leverage is more than double the lows of the cycle and close to a 25-year high. Excluding energy, small-cap debt accumulation has outpaced Ebitda [earnings before interest, taxes, depreciation and amortization] growth nearly fourfold since 2008,” the research note said. Ebitda is a measure of company’s cash flow.
Other concerns about small-caps include the fact that they historically don’t perform well during monetary tightening cycles.
Yet, upside momentum for small-caps could continue for some time, according to, Kim Caughey Forrest, senior analyst and portfolio manager at Fort Pitt Capital Group.
“So far, earnings are coming in better than expected and commentary from companies is also positive. As the U.S. economy is still better than in any other part of developed world, small-caps will continue to be attractive,” Forrest said.