Small-cap stocks are poised for a powerful catch-up rally in the next six to twelve months, according to Sean Gallagher, the global head of Lazard’s small-cap equity platform. After years of lagging behind large caps, Gallagher predicts a surge in small caps, as tracked by the iShares Russell 2000 ETF (IWM), of between 30% and 50% in the coming year. This surge, he believes, will close the gap with their large-cap counterparts.
In an exclusive interview with Benzinga, Gallagher highlighted the stark valuation gap between small and large caps, a key driver of his bullish outlook. “Small caps have been lagging significantly for an extended period,” he stated.
Gallagher’s optimism hinges on the Federal Reserve’s anticipated pivot towards rate cuts. This shift, he believes, will provide the necessary tailwind for small caps to outperform. “We feel very good that inflation is on a downward trajectory, and we expect the Federal Reserve to begin cutting rates soon. This should provide a much-needed catalyst for small caps to catch up with large caps,” Gallagher explained. Lazard projects up to 200 basis points of rate cuts in the coming year, a move that Gallagher believes will significantly lift small-cap stocks due to their higher leverage and sensitivity to borrowing costs.
The sheer size of the valuation gap between small and large caps is another driving force behind Gallagher’s bullishness. “The median price-to-earnings (PE) ratio for small caps, excluding non-earners, stands at 9.5 times, which is incredibly attractive compared to large caps,” he said. While the broader small-cap index might initially appear less compelling, Gallagher pointed out that the roughly 18% of small-cap companies that are non-earners skew the overall picture. “When you remove the non-earners from the index, small caps look exceptionally cheap,” he added. The numbers speak for themselves: small caps have underperformed the S&P 500 by 10 percentage points this year, 30% over the past three years, and nearly 50% over the past five years.
Lazard’s small-cap strategy heavily favors sectors poised to benefit from a lower interest rate environment. Gallagher highlighted financials, healthcare, and consumer durables as particularly attractive sectors. Healthcare spending, particularly in biotech, has been muted recently, but Gallagher believes lower borrowing costs could rekindle investment in this area. He also sees significant potential in consumer durables, particularly companies with debt-heavy balance sheets, which stand to benefit from reduced financing costs. “Many consumer durables companies have felt the impact of elevated rates, but we expect them to rebound strongly as borrowing costs decline,” he added.
Gallagher also touched upon the potential political implications for small-cap stocks, particularly with the upcoming 2024 U.S. presidential election. Historically, small caps have performed better under Republican administrations, which tend to favor lower taxes and pro-market policies. “While the election outcome remains uncertain, a Republican-led White House could be a tailwind for small caps, especially if it leads to tax cuts or reduced regulation,” Gallagher stated. It’s worth noting that Goldman Sachs analysts predict stronger GDP and job growth if Democrats sweep the White House and Congress.
Despite his overall bullishness, Gallagher acknowledges several risks that could derail the small-cap rally. The most significant risk is the potential for the Federal Reserve to fall behind the curve in addressing economic softening. “We’re seeing some signs of economic slowdown, particularly in consumer and industrial sectors, but it’s not flashing recession to me just yet,” he said. Gallagher emphasized the importance of the Fed acting swiftly to cut rates, ensuring the economy doesn’t lose too much momentum before the rate cuts take effect. “We just need to get from here to there, and as long as the Fed acts in time, I believe we can avoid a significant contraction,” he added.
