Key Takeaways:

• After a decade of underperformance, small cap valuations have reached historic lows, a potential precursor to the start of a small cap cycle.

• High but declining inflation, coupled with rising rates, and improving earnings provide a favourable macro backdrop and potential catalysts with historical precedent.

• 40% of the Russell 2000 Index is unprofitable. Buying the index is no longer good enough; active management will be paramount going forward.

2022 has been a year marked with tremendous market volatility and a broad move away from risk assets across the globe, few more pronounced than in the small cap market. In fact, in the past decade, small caps have lagged large caps (as measured by the S&P 500 Index) by over 220 bps per year, on average. This timing coincides with the duration other small and large cap market leadership cycles throughout history, and suggests a shift in market cap leadership may be on the horizon.

Valuations are at historic lows

Perhaps the most compelling aspect of small caps are relative valuations compared to their large cap counterparts. Given the extended run of underperformance vs large caps – the Russell 2000 Index has underperformed the S&P 500 Index in eight of the past 12 years – valuations are very attractive. In fact, they have only been cheaper 27% of the time (based on J.P. Morgan Asset Management research). This valuation level is similar to prior outlier periods like the tech bubble in the 1990s and the great financial crisis in 2008.

More importantly, the performance of small caps coming out of these periods is quite compelling. In the 10 years following the tech bubble, small outperformed large eight out of ten times and by over 400 basis points (bps) per year on average, when you compare the Russell 2000 vs its large cap counterpart, the Russell 1000.

Past performance is not a reliable indicator of current and future results. Source: J.P. Morgan Asset Management. Data is based on a composite of proprietary valuation factors for stocks in the Russell 2000 Index vs the Russell 1000 Index. Data from December 1989 – December 2022. Opinions, estimates, forecasts, projections and statements of financial market trends are based on market conditions at the date of the publication, constitute our judgment and are subject to change without notice. There can be no guarantee they will be met.

Small caps have certainly taken an outsized beating this cycle, currently representing just 6% of overall total US equity market value vs its historical average of close to 8%. The only other times we’ve seen small cap index representation this low was during the prior outlier periods, namely August 2020 and November 1999.

Active management is key within small cap

While we certainly do see headwinds for small caps in the near to mid-term, with stubbornly high inflation and tightening monetary conditions, empirically, small caps tend to outperform during this part of the cycle. Using history as a guide, small caps have done well in periods of rising rates and periods of high, but declining, inflation.

As monetary conditions remain tight and the Federal Reserve (Fed) tries to glide the US economy to a soft landing in 2023, we also believe that active management is paramount. The small cap market is fraught with landmines – weak companies that have been able to survive in this era of easy money – so investors need to be discerning. To illustrate the point, at the end of 2021 approximately 40% of companies in the Russell 2000 Index were unprofitable. Compared to history, this percentage has only been higher 9% of the time! As rates continue to move higher and the US economy weakens, these unprofitable companies face mounting pressure.

Additionally, with a recession looming in Europe, small cap’s domestic bias should act as a tailwind. On aggregate, only 22% of revenue comes from overseas for Russell 2000 companies, while S&P 500 constituents derive more than double that percentage from abroad. While passive beta may have provided investors enough return over the past few years, the experience and expertise of a team of active portfolio managers is essential to selecting only the highest quality small cap stocks.

Are we there yet? Not quite, but getting close

There are certainly unique challenges for the broader market heading into 2023, and small caps are not immune to these challenges. Risk equities are likely to face continued heightened volatility due to the uncertainty of the Fed’s campaign for financial tightening, and the economic response that comes with it. But despite these headwinds, small cap cycles tend to begin, and end, at bear market troughs, driven largely on valuation. Given the profound valuation dispersion we’ve discussed, once investors have some clarity about the health of the US economy and risk assets are back in vogue, we may be witnessing the early stages of a rewarding small cap cycle.

Past performance is not a reliable indicator of current and future results. Source: J.P. Morgan Asset Management. Data from January 1993 – November 2022. Small cap represented by Russell 2000 Index, large cap by S&P 500 Index. Opinions, estimates, forecasts, projections and statements of financial market trends are based on market conditions at the date of the publication, constitute our judgment and are subject to change without notice. There can be no guarantee they will be met.

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