The tide could be turning in favor of small-cap equities, with experts predicting a potential resurgence after a decade of outsized returns from the US large-cap sector.
Vanguard, in its latest market perspective, identifies the US small-cap sector as a leading domestic opportunity, projecting an annualized return of 5% to 7%. However, they also acknowledge a median volatility of 22.6%, the highest among domestic sectors.
This optimistic outlook stems from the resolution of labor market imbalances following the COVID-19 pandemic. Adam Schickling, a Vanguard senior economist, states, “Our non-accelerating inflation rate of unemployment estimate suggests that the labor market has reached a healthy balance.” While Vanguard anticipates additional rate cuts, they don’t expect a rapid cycle of cuts based on current labor market conditions.
Looking ahead to 2024, Vanguard sees small-cap stocks as “attractive in the long term.” Fidelity echoes this sentiment, expecting rate cuts to create a favorable investment environment.
The performance of these sectors in 2024 further fuels this optimism. The S&P 500, a benchmark for large-cap stocks, is up 22.9% year-to-date, while the small-cap focused Russell 2000 has seen a gain of around 11.4%.
While the potential for a small-cap resurgence is compelling, investors should be aware of the inherent volatility of this sector. James Battmer, Chief Investment Officer at Creative Planning, cautions, “Mean reversion is a concept we believe in, but the timeline is unpredictable. It could happen in the next decade, or it could take much longer.”
This potential shift highlights the importance of diversification. While past gains from giants like Nvidia, Tesla, and Netflix have been remarkable, Battmer argues that continuing this growth trajectory is unlikely. “If they were to replicate the same growth, they’d be larger than the entire US economy, which is a near-impossible scenario.”
Investing in a broad range of stocks, not just the “big winners”, is crucial for long-term success, as illustrated by the “lost decade” for large-cap growth in the early 2000s. During this period, a growth-focused portfolio could have lost a significant portion of its value.
The potential for a small-cap comeback offers a compelling investment opportunity, but investors should approach it with caution and a focus on diversification, recognizing the inherent volatility of the sector.
