We believe we are in the early days of the next bull run in small caps. While being early to shifts in sentiment may come with bouts of volatility and underperformance, we think small cap investors are better off being early than late.
Relative Size Dynamics
After an extraordinary run of large caps relative to small caps since 2019, the market cap of the Russell 1000 stands at $53.5 trillion—nearly 20 times larger than the market cap of the Russell 2000 Index, up from just 12 times in 2018.1 What might that mean? In our view, if investor sentiment were to shift toward small caps, we believe the relative size of the two categories implies that a mere 1% reallocation from large to small caps could boost small cap returns by 20%.
Favorable Macro Drivers
- Interest rate cuts: The Fed’s latest easing cycle may well be good news for small caps. In past rate-cutting cycles, small caps have often outpaced large caps by eight percentage points.2
- Weakening USD: We believe multi-year U.S. dollar cycles negatively correlate with the relative valuations between small and large caps. (As the USD weakens, small cap valuations tend to rise vs. large caps, and vice versa.) Historically, USD cycles tend to last 7-10 years; the USD has been strong for more than 13 years and, in our view, appears expensive on many traditional measures.3
- Improved access to credit: Small caps can struggle with high borrowing costs. Relatively low bond yield spreads and loosening lending standards should support small cap growth, in our view.
- Reviving global capex: We believe a global capex revival has the potential to boost small cap earnings. As the source of small caps’ total return shifts from rising P/E multiples to rising earnings, more skeptical investors could be drawn off the sidelines.
Historically Wide Valuation Gap
At current levels, history suggests to us that high-quality (i.e. profitable) small caps have the potential to significantly outperform large caps over the next decade. (For more detail on the size of this gap and what it might portend for investors, please see our recent report, “Small Caps: The Next Cycle is Upon Us.”