A Cost-Effective Approach to US Economic Exposure
Large-cap US companies often operate on a global scale, making their revenues more sensitive to the global economic environment. In contrast, small- and mid-cap companies are generally more focused on domestic markets, providing investors with more direct exposure to US economic performance. Given the current high valuations of large-cap stocks, small- and mid-cap stocks present a more cost-effective alternative for investors seeking to benefit from the robust US economy. As illustrated in Figure 1, the price gap between small and large caps highlights that gaining or increasing exposure to US economic strength does not have to come with a high price tag.
Key Trends Favoring Small- and Mid-Cap Stocks
While small- and mid-cap stocks have traded at a discount to large caps for several years, the landscape is shifting as we approach 2025. In addition to the continued strength of the US economy and attractive valuations, several emerging trends could converge to create a highly supportive environment for small- and mid-cap stocks.
Small Caps Take the Lead
In the first half of the year, large caps dominated the market, with the S&P 500 and NASDAQ 100 outperforming small caps (Solactive 2000) by more than 16% and 18%, respectively. However, the momentum has shifted in the second half. Small caps have surged over 9%, significantly outpacing the S&P 500's gain of just over 2% and the NASDAQ 100's less than 1% increase.
The early-year returns were heavily concentrated at the top: just four companies—Nvidia, Microsoft, Alphabet, and Amazon—accounted for more than half of the S&P 500's growth, while nearly 40% of the index posted negative returns. In contrast, the second half has seen a broader rally, with only 20% of the index recording negative returns, including the four previously dominant companies.
Three Factors Driving the Current Momentum
Fundamentals The Federal Reserve appears to be entering a “Goldilocks” scenario, where inflation is declining, and economic growth is moderating without stalling. Recent data reinforces this narrative: the latest CPI report showed the first month-over-month decline since 2020, and Bank of America’s Institutional Fund Manager survey revealed that higher inflation is no longer the top risk for investors.
Consumer strength remains a key driver. June retail sales in the critical control group were more than four times higher than expected, and the Atlanta Fed’s GDPNow model projects 2.7% GDP growth for the second quarter. However, nearly 40% of investors surveyed believe monetary policy is overly restrictive, the highest level since 2008. This combination of stable growth, easing inflation, and potential rate cuts creates a favorable backdrop for risk assets.
At a micro level, nearly 40% of the Solactive 2000 (small caps) are unprofitable and rely heavily on capital markets for financing, unlike large caps, which can fund operations through cash flow. As a result, lower rates disproportionately benefit small caps.
Technicals Small-cap stocks, given their smaller size and lower liquidity, are more influenced by technical factors. Hedge funds began the month with near-record short positions in small caps, creating conditions for a powerful rotation when the market shifted.
This shift wasn’t solely due to short covering. For the week ending July 12, equity ETFs experienced their second-highest inflows of 2024. While large-cap ETFs received the most nominal dollars, small caps were the relative standout. The iShares Russell 2000 ETF saw inflows of $3.7 billion—over 6% of its market cap—compared to a 2.4% inflow relative to market cap for the SPDR S&P 500 ETF.
Political Landscape According to PredictIt, there is now a 63% chance of a Republican presidential victory in 2024, an eight-point increase from the previous month. As noted in our Mid-Year Outlook, small-cap equities are poised to benefit from expectations of lower taxes and reduced regulatory burdens under Republican leadership.
For only the second time in its history, the Solactive 2000 index reached a new 52-week high after a five-day 10% rally. The last instance occurred on November 11, 2016, the business day after Donald Trump’s election as President. Following that rally, the index gained an additional 7% over the next month and was up 14% a year later.
Wall Street forecast
Wall Street anticipates a stronger rebound in small-cap earnings beginning in Q4 2024 and continuing through much of 2025.
The challenges that made 2023 particularly tough for small caps—such as rate hikes and the aftermath of Silicon Valley Bank’s collapse—are likely behind us. These improved conditions may help explain why a consensus of Wall Street analysts predicts that small-cap earnings growth will outpace that of large caps in Q4 2024 and in every quarter of 2025 except the first.
Artificial intelligence (AI) requires far more than the advanced chips produced by companies like NVIDIA. For instance, thermal management solutions are essential to handle the intense heat generated by AI chips. Optical communications play a pivotal role in delivering the high bandwidth, low latency, and data capacity needed to meet the immense processing demands of AI applications. Equally important are data storage and management, software development, and cybersecurity. Small-cap companies frequently serve as key contributors—and often leaders—in these industries, positioning them to both shape and benefit from the transformative growth driven by the AI revolution.
A Reminder: Market Leadership Rotates Over Time
The prolonged dominance of large caps since the end of the Global Financial Crisis can make it easy to overlook that market leadership does rotate. From 2000 to 2006, small caps experienced their own period of outperformance, showcasing their ability to deliver strong returns across varying GDP conditions and federal funds rate environments, as illustrated in Figure 5. This serves as an important reminder that extended periods of outperformance have never signaled a permanent shift in market dynamics.
Small caps have ouperformed in various regimes
Conclusion
The recent debate over large versus small caps has been complicated by the fact that much of the market’s post-pandemic rally was driven primarily by the "Magnificent Seven" stocks. However, signs of market broadening beyond these seven emerged in 2024, benefiting not only other S&P 500 constituents but also small- and mid-cap stocks. While no one can predict exactly when the inevitable rotation from large- to small-cap leadership will occur, there are ample indications that small- and mid-cap stocks deserve a meaningful allocation in investors' portfolios heading into 2025 and beyond.
After several years of substantial gains in mega-cap stocks, your equity portfolio may be more heavily weighted toward large-cap stocks. Investing in quality small cap stocks offers not only opportunities for long-term growth but also diversification benefits by broadening exposure across the market-cap spectrum. Additionally, their discounted valuations present a compelling entry point.
How much should you consider allocating to SMALL cap stocks? We suggest that dedicating 5%–10% of an overall equity portfolio to SMALL stocks—provided it aligns with your time horizon and risk tolerance—can enhance risk-adjusted returns. Even a modest reallocation can have a significant impact.
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