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Calling the “bottom” on small caps has been a difficult task.BRENDAN MCDERMID/Reuters

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Small capitalization stocks have been performing poorly since they reached an all-time high in November 2021 as shown by iShares Russell 2000 ETF IWM-A. But that could soon change as we approach the end of 2023.

Small caps have been underperforming the S&P 500 and large-cap sector represented by iShares Russell 1000 ETF IWB-A for even longer – since March 2021.

Small-cap companies are considered higher risk and have more volatility compared to large caps, on average and over the long term. That’s supposed to translate into small caps providing a greater rate of return on average over the long term, which has not been the case over the past few years.

During this past year, investors have been focused myopically on the technology sector – particularly a handful of stocks. The seven large-cap stocks that have largely contributed to the S&P 500′s positive performance have become known as the “Magnificent Seven”: Microsoft Corp. MSFT-Q, Inc. AMZN-Q, Meta Platforms Inc. META-Q, Apple Inc. AAPL-Q, Alphabet Inc. GOOG-Q, Nvidia Corp. NVDA-Q, Tesla Inc. TSLA-Q.

Overall, investors have been asking themselves if they need to own the small-cap sector if the large caps are producing the bulk of the returns in the stock market. Why take on seemingly more risk with small caps when the sector continues to underperform?

That, in turn, has resulted in a self-fulfilling prophecy. As more investors shift from small caps to large caps, the stronger the performance of large caps and the weaker the performance of small caps.

The COVID-19 pandemic gave large-cap companies a financial advantage over smaller ones. Large companies with more stable businesses were able to take advantage of low interest rates and arrange long-term loans. Although small companies were able to take advantage of low interest rates, they were not able to do so to the same degree as large caps.

Generally, small companies operate with a much shorter loan structure due to the nature of their businesses being faster growth and having a less predictable revenue stream over the long term. As interest rates have climbed, that has had a much larger impact on small companies compared with large ones.

Focus on valuations and seasonal trade

So, where do things stand today? The value of the large-cap sector has risen to a level at which it now has a trailing 12-month price-to-earnings (P/E) ratio of 22.2. This compares to the Russell 2000, which has a P/E of 10.9. Generally, over the long term, it’s expected that smaller companies will have a higher P/E ratio due to their faster rate of growth. That’s not currently the case.

When could small caps turn the corner and start to outperform large caps?

Calling the “bottom” on small caps has been a difficult task. There’s one trade that has worked well for small caps over the past few years despite the overall underperformance. That’s the seasonal trade from Dec. 19 to March 7 in which small caps tend to outperform both large caps and the S&P 500.

During this period, small caps (Russell 2000) outperformed large caps (Russell 1000) by 2.3 percentage points, on average, from 1979 to 2023. In addition, the small-cap sector has beaten the large cap sector 66 per cent of the time. During the past few years, the trade has worked well, on average, including last year.

Small cap effect strategy

Why does the trade tend to work from Dec. 19 to March 7? For one, investors tend to sell their losing stocks, particularly small caps, at the end of the year to offset any capital gains that were generated during the year.

This year, the effect could be pronounced as large-cap stocks have managed to perform well and small-cap stocks have languished. Selling small caps late in the year tends to push the sector lower into the second half of December, which, in turn, becomes an attractive buying opportunity.

The second reason small caps tend to perform well in their seasonally strong period is that money managers tend to increase their beta (risk) early in the year to build a comfortable outperformance buffer relative to their benchmarks. If the strategy doesn’t work, they, at least, have the rest of the year to make up the difference.

There are no guarantees that any strategy will work, including the small-cap effect. Nevertheless, given the substantial underperformance of the small-cap sector relative to large caps and small caps’ much lower P/E ratios, the sector could be primed to outperform starting mid-December.

Brooke Thackray is research analyst at Horizons ETFs Management (Canada) Inc.

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Tickers mentioned in this story

Study and track financial data on any traded entity: click to open the full quote page. Data updated as of 01/03/24 4:00pm EST.

SymbolName% changeLast
Tesla Inc
Nvidia Corp
Alphabet Cl C
Apple Inc
Meta Platforms Inc
Microsoft Corp
Russell 1000 Ishares ETF
Russell 2000 Ishares ETF

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