Are Small-Cap Stocks Shining Again? Here's What You Need to Know

As small-cap stocks are notably sensitive to changes in interest rates and economic conditions, high interest rates and persistent concerns about an impending economic downturn had initially exerted pressure on their stock prices. These were the two most significant factors affecting small-cap stocks.

However, now that market expectations suggest that the Federal Reserve will not increase interest rates this year and may cut rates in the first half of next year, and fewer voices are discussing the possibility of an economic recession, small-cap stocks have once again regained investor interest amidst a recovering market sentiment.

Despite higher operating uncertainty, small-cap stocks are often associated with high growth and growth potential. As the economy improves, these small and medium-sized companies may demonstrate greater performance flexibility than larger companies. Earnings for Russell 2000 companies are expected to rise 30% next year after falling 11.5% in 2023, LSEG data shows.

According to LSEG Datastream data, the relative value of U.S. small-cap stocks compared to large-cap stocks is currently at historically low levels. The lower valuations can offer a crucial margin of safety for investors who allocate their funds towards small-cap stocks.

In retrospect, small-cap stocks have demonstrated a tendency to rebound strongly following a period of below-average returns. When looking at all five-year periods for the Russell 2000 Index in which the annualized return fell below 5%, subsequent three-year annualized returns turned positive, with the average rebound being as high as 17.5%. Historical data also shows that U.S. small-cap stocks tend to lead gains when the market recovers. Following the historic performance after the final Fed rate hikes, the Russell 2000 Index saw an average annual rise of 18.4%.

Despite the strong rebound that has sparked optimism among investors, small-cap stocks still pose some risks that cannot be overlooked, according to analysts. The first of these is high volatility, with small-cap stocks experiencing nearly 25% volatility in the past five years. Additionally, difficulty in generating profits is another criticism that small-cap stocks face. A mid-November report by Apollo Global Management indicated that around 40% of companies listed on the Russell 2000 index are currently operating at a loss.