Shares of small-caps have outperformed the broader market during its rebound this month. That's a short-term trend -- don't expect it to continue much longer.
The S&P 600 index, which tracks companies across sectors with an average market capitalization of $3 billion, was up 3% Friday and has gained 10% since hitting the floor Aug. 5. That beats the 7% gain in the large-cap S&P 500 since its Aug. 5 low.
The rebound comes as investors have scooped up beaten down stocks, which may continue to produce growing earnings for this year and next as the economy remains in growth mode.
Sure, growth has slowed down as consumers feel the pinch of elevated interest rates, but the economy still hasn't hit a recession. Plus, with inflation dropping, the Federal Reserve is likely to cut rates in September.
Small-caps have been seeing daily spikes here and there when the Fed implies a rate cut is on the way -- including a 10% jump by the S&P 600 one week in July. Now, the rally is likely to peter out.
The S&P 600, at just over 1400, remains below its multiyear high of 1429, which it hit in July. And it's well below its record high of 1465, hit in late 2021. Rallies have continued to fizzle out near these levels because there aren't enough buyers at these prices, given the risks.
The market isn't supremely confident in the economy, and smaller companies' earnings are volatile. They see larger upswings when the economy improves and larger downswings when it weakens.
While falling rates are comforting, rates are still well above the 0% level they were at before the Fed started hiking in early 2022, and the full extent of the damage to the economy usually unfolds over periods of months to years. The market is concerned that, even with rates going down from peaks, the economy is in for sluggish growth or even some sort of recession.
"Small-caps can outperform when the economy is accelerating," writes Trivariate Research's Adam Parker. "Given it just began to incrementally decelerate, and the first Fed cut doesn't appear to be accompanied by additional fiscal stimulus...we are skeptical that there will be a short-term tangible benefit [for small-caps]."
To that point, the risk is that small-cap sales and earnings estimates will decline from here.
Real gross domestic product growth has recently hovered the low-single digits and the rate of inflation -- think price increases -- is about the same. Together, that should enable moderate sales growth for companies.
But right now, analysts estimate that aggregate sales for companies on the S&P 600 will grow at just below 8% annually from the end of this year through 2026, according to FactSet.
That would land 2026 revenue at a level that is 18% above that of 2022, before higher rates started to take a substantial bite out of economic demand. That's a staggering increase, especially given that S&P 600 sales grew at just under 9% annually from 2010 to 2022 -- and the growth decelerated in 2018 and 2019, when the economy had already seen the best of its post-financial crisis growth. So sales estimates may need to drop from here.
Dropping revenue expectations would likely cause an even greater percentage fall in profit estimates. Companies can't reduce all costs -- some expenses are fixed -- so falling revenue forecasts would mean lower profit margin projections, further pressuring bottom line dollars.
The takeaway is that small-caps aren't likely to outperform large-caps until the market sees proof economic growth is reaccelerating.
That's why Parker recommends holding on to large-caps, including Big Tech, which is still growing sales and earnings on the back of artificial intelligence.
Don't be tempted to put too many small-cap stocks in the portfolio right now.
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