Small-cap surge: Outpacing large caps on hopes for '24 rate cuts

Key Points

• The small-cap S&P 600 has been outperforming the large-cap S&P 500 in the past three months.
• Small caps struggled in 2023 due to high-interest rates, which impacted external financing and growth potential, but investors are more optimistic now.
• Forward P/E ratios currently favor small caps, with S&P 600 at 15.7, lower than the S&P 500.

Sure, the S&P 500 has come on strong since late October, but if you compare the three-month performance of the SPDR S&P 500 ETF Trust NYSEARCA: SPY versus the SPDR Portfolio S&P 600 Small Cap ETF NYSEARCA: SPSM:

• SPY: +12.30%
• SPSM: 17.52%

In the past month, small-cap outperformance is even more pronounced, with a gain of 14.74% versus large caps’ return of 5.27%. 

The largest component in the S&P 600 is e.l.f. Beauty NYSE: ELF, which has returned 160.49% this year, and is up 30.53% in the past three months. 

The S&P 600 is still trading slightly below its November 2021 high, but is within striking distance of overtaking that $479.98 high. Shares closed at $476.69 on December 28.

High interest rates hurt small companies more

Small caps suffer more from high interest rates. That’s because smaller companies often rely more on external financing, whereas larger companies frequently have large cash reserves.

In addition, smaller companies often don’t have the borrowing capacity or flexibility of larger companies. Higher rates may impede their ability to grow. 

Also, economic uncertainty also affects small companies, as investors may shift their dollars to larger, more stable dividend-paying stocks. 

That thesis worked well throughout most of 2023, but since the Federal Reserve signaled in December that interest rates may be cut in 2024, small caps’ growth has been nothing short of spectacular. 

Rallying back after glut of bad news

As often happens, bad news set up small caps for the current rally. The difficulties with borrowing, as well as market sentiment that favored larger stocks and inflationary pressures that increased materials and labor costs put a damper on small-cap performance until recently. 

The rally isn’t particularly surprising; eventually, investors see bargains and begin to scoop up shares. 

The forward P/E for the S&P 500 is 19.8, versus 15.7 for the S&P 600. For investors seeking a more attractive valuation, small stocks could be the ticket. 

Investors have fretted about economic growth, but with the much-hyped recession yet to occur, and with more investors convinced the Fed’s series of rate hikes have ended, small caps are looking more and more like bargains. 

Investors paying up for small-cap growth

For example, analysts expect e.l.f. Beauty to grow earnings by 63% in 2024 to $2.71 per share. Like many large-cap growth names, e.l.f.’s valuation is a bit rich, with the stock trading at a multiple of 53 times forward earnings. 

However, with growth stocks, no matter the market capitalization, investors expect to pay up for those future earnings. As an asset class, small-cap growth, tracked by the SPDR S&P 600 Small Cap Growth ETF NYSEARCA: SLYG, has slightly outperformed all S&P 600 stocks this year, but underperformed slightly on a one-month basis.

How about small-cap value?

The SPDR S&P 600 Small CapValue ETF NYSEARCA: SLYV has slightly underperformed the wider small-cap index this year, but slightly outperformed in the past month. 

Growth and value both attractive now

In other words, investors are eagerly buying both growth and value small caps right now. 

That comes back to small stocks, as an asset class, being cheap relative to larger stocks, which have been in rally mode throughout most of 2023. In addition, with lower interest rates and more cash on hand to fund new projects, small-cap stocks could be in a better position to grow sales and earnings. 

Small stocks currently poised for gains include:

• Bloomin’ Brands Inc. NASDAQ: BLMN: The parent company of Outback Steakhouse has been forming a cup-shaped pattern and is trading just shy of its buy point north of $28.67. Analysts expect 16% earnings growth in 2023. Both Bloomin' Brands and e.l.f. are considered consumer discretionary stocks. 
• SPS Commerce Inc. NASDAQ: SPSC: This $7.2 billion market cap company specializes in cloud-based supply chain management. The SPS Commerce chart shows the stock clearing a double-bottom base above $188.76. It closed at $196.21 on December 28, up just 3.9% from that buy point, meaning it’s currently in an actionable zone. 
• Meritage Homes Corp. NYSE: MTH: Lower interest rates are not only helping small caps, but also homebuilders, meaning this company could be in a sweet spot. The stock is currently trading in a sideways pattern following a big gap-up following news about possible rate cuts. Sideways trade is often a precursor to more price gains.