History shows that smaller-cap stocks are much more closely tied to the domestic economic cycle than larger-cap stocks. As a result, economic recessions have often represented exceptional buying opportunities for these equities once the cathartic final “dip” at the start of most recessions is out of the way.
The fact that the economy today is still not in recession is making investors wary that either it continues to expand, limiting the potential for any expected future rate cuts, or that higher rates will eventually “break something” and drag down the more volatile smaller-cap stocks with it. Adding to these woes is the sheer dominance and market power of many of the largest-cap stocks today, as well as the introduction of private equity as a major player in the smaller-cap space, which may have already squeezed the market for these stocks. In short, it is not hard to see why investors have shunned smaller caps.
Nevertheless, while neither the economic cycle nor the expected rate environment would seem to currently support a small-cap rotation, there are similar parallels between the start of the 1998-2006 small-cap cycle and today. Only today, there is at least a strong probability that interest rates have already peaked, while valuations are even more attractively priced across just about all available metrics. This would suggest that many of the fears investors have been harboring about smaller-cap stocks have already been priced in, helping to provide a wider margin of safety and interesting opportunity for more valuation-conscious investors at the higher-quality end of this market.