A closer look at small-cap stocks (2024)

As the U.S. economy glides to a soft landing and inflation fades, investor focus has turned from asking how long interest rates will remain high to how soon economic growth will rebound. Because the market for small-cap stocks has historically performed well in economic recoveries, the recent turn in sentiment has justifiably prompted many investors to take an interest in this market.

In our view, the 2024 outlook for the asset class is promising. But we encourage investors to reject some of the simpler arguments for their imminent success and consider looking at the asset class from the perspective of the role it could play in an overall portfolio, and the value it can provide from active management.

Timing the small-cap market is difficult

Broadly speaking, small-cap stocks are more sensitive to economic growth than large-cap stocks (twice as sensitive by some measures) and thus it is reasonable to assume that the rosier your economic outlook the more optimistic you should be on small-cap returns. But the devil is in the details, and getting the right entry and exit points for small-caps is notoriously difficult.

The chart below confirms that small-cap stocks (represented by the Russell 2000® Index) have historically outperformed the large-cap market (represented by the Russell 1000^® Index) after a recession (the grey-shaded areas in the chart), and often begin their outperformance before the recession ends. Clearly, after the recessions shown in the chart, small-cap stocks have seen an extended period of outperformance, often substantial and lasting for years.

But where are we in the cycle today? While growth was never low enough to produce a technical recession in the current cycle, surging growth in late 2023 could indicate that the economy bottomed in the third quarter. But it is more likely that the U.S. economy hasn’t bottomed yet. This is in line with our view (and the majority of market forecasters) that the economy will continue to slow in 2024 but have a soft landing, rebounding late in the year or next year. However, forecasting the pace of economic growth is difficult and forecasting turning points in the economy is even more difficult. A majority of economists, for example, predicted a recession in 2023, and yet it never materialized.

Standard valuation metrics may help, but here too the devil is in the details. As of January 2024, the Russell 2000 Index is enduring its longest drawdown (languishing below a previous high) in the index’s history. While one could argue that small-caps are thus due a period of outperformance, one could have plausibly argued this at many points in recent years, pointing to lagging performance, positive technical factors and attractive valuations.

As the chart above shows, for six out of the last seven years—through various economic, political and technical ups and downs—large-cap stocks have outperformed the small-cap market, steadily pushing relative valuations to further extremes. There is the opportunity for valuations to remain cheap for much longer than seems reasonable. Simply put, valuations have a mixed track record as a good indicator of near-term performance. Why will it be different this time?

The 2024 outlook for small-caps is promising

There are both fundamental and technical reasons to be optimistic about the small-cap market this year. The foremost is the likelihood of an economic recovery and the boost that may provide small-cap earnings. Corporate profits broadly have already bottomed, and they are currently accelerating for many large-cap companies. History tells us that periods of improving earnings-per-share growth—even if the economy is still slowing—disproportionally benefit small-cap companies.

While this argument may assume improving—even bottoming—economic growth should lead to a wider range of companies seeing competitive returns, this does not strike us an unreasonable assumption. 2023 saw the narrowest dispersion of returns since the 1980s. Only 27% of companies on the S&P 500^® Index outperformed the index last year, and just (a magnificent) seven of these were responsible for 30% of its 2023 return. While the strength and speed of a recovery is unclear, we remain optimistic that small-cap earnings could catch up to the broader market by the end of 2024 as the economy recovers and the dispersion of returns broadens.

Finally, assuming inflation does not reverse its current trend, the U.S. Federal Reserve (Fed) should lower interest rates in 2024, also disproportionately benefiting small-cap companies. Broadly speaking, small-cap companies tend to hold more debt than larger ones, making their profits more sensitive to the cost of servicing this debt. Lower interest rates will help. Additionally, small-cap companies typically hold more floating rate debt as they have more bank funding than larger companies that favor financing in the corporate bond market. Given that U.S. floating rate interest is ultimately tied to the Fed’s monetary policy rate, any cuts to this rate would have an immediate impact.

Turning to more technical factors, a small improvement in sentiment toward small-cap stocks could have a large (and potentially rapid) impact on returns. Because the asset class has languished in recent years (and the economy was thought to enter a recession last year), many strategic investors may be underinvested, as can be seen in the chart below. It is possible that a virtuous circle of improving sentiment could lead to increased inflows to the asset class—boosting returns—further boosting sentiment.

Meanwhile, current small-cap price/earnings (P/E) ratios are about 25% below their average relative to large-cap P/E ratios—an extreme level not seen since the dot-com euphoria days about 20 years ago. On a price basis, the gap between the Russell 2000 Index and the Russell 1000 Index is near two standard deviations below its average. Simply put, a variety of valuation measures suggest small-cap stocks are the cheapest they have been since 2007.

The argument for strategic exposure to small-caps

The chart below shows that over the past 30 years small-cap stocks significantly outperformed large-cap stocks. While the exact amount will vary according to the time period chosen (and in recent years it has been consistently negative) there are compelling arguments for long-term strategic allocations to the asset class.

First, small-cap stocks are generally more volatile than large-cap stocks. This can be seen in the chart above by comparing the sharp rises and swift plunges of the tan (small-cap) line relative to the more stable black (large-cap) line. While volatility may intuitively be a bad thing, it typically comes with a corresponding return premium to compensate investors for taking additional short-term price risk. For long-term strategic investors less sensitive to short-term volatility, any additional premium offered could be seen as an attractive asset.

The chart above also highlights just how quickly periods of small-cap strength can materialize. In the 2020-2021 spike visible above, when global investors began to price in a COVID-19 vaccine, small-cap stocks outperformed large-caps by around 40% in less than six months. To the extent there are reasons to be optimistic about the short-term (one-year) performance of small-caps, and the market is difficult to time, investors may be better served simply holding an appropriate amount of the asset class for their individual risk and return targets.

There are also larger economic trends that could disproportionately boost small-cap stocks in the years ahead. For example, there are compelling arguments that technological advances like cloud computing and artificial intelligence are helping to level the playing field between small and large companies, allowing smaller companies many of the advantages that only their larger competitors had enjoyed. More generally, the U.S. economy is increasingly reliant on technology, the country is the world’s leading technological innovator. Small-cap investors may be rewarded for patient, long-term allocations.

The active management advantage

In our view, the most compelling argument for small-cap stocks to offer long-term strategic value is the potential for active management to offer incremental returns over a benchmark, lower a portfolio’s risk, or both.

The primary reason such an opportunity exists is a lack of efficiency in how small-cap stocks are researched compared to their large-cap counterparts. The small-cap universe is relatively under-analyzed, with the median stock covered by just five professional analysts compared to the median S&P 500 stock which has 18. There are hundreds of small- and mid-cap stocks in any particular region not covered by a single professional analyst. If you have the time and resources, you can—in principle—know a company better than anyone else.

That individual small-cap company returns are less normally distributed than large-caps only heightens the opportunity for active management. Put plainly, there are more dramatic winners and losers than one would normally expect in a typical equity market so the value of having professional analysis is helpful in identifying winners and losers.

Finally, the reasons small-cap returns are less normally distributed is probably related to a higher correlation between a company’s earnings and its stock’s return. To exaggerate the point, small-cap stocks tend to win or lose in the market based on their profitability. With less external factors influencing a stock’s price, knowing a company better than anyone else becomes more valuable.

Top considerations of adding ESG metrics

The ability to generate incremental returns, in our view, is enhanced when done through an environmental, social and governance (ESG) lens. In the past decade, multiple comprehensive studies have confirmed through empirical evidence that there is a correlation between ESG performance and financial performance, with one of the largest meta-studies incorporating over 2,000 empirical studies, 90% of which demonstrated either positive or neutral correlations between ESG factors and financial performance.¹

Because the core process of ESG analysis focuses on long-term sustainability, it can help identify companies that are building a more compelling competitive approach. ESG analysis can also offer a unique perspective on a company’s risks, helping to further screen out companies which may not have the same potential for long-term stability and growth. An approach to incorporating ESG factors into the investment process involves analyzing companies' effects on their stakeholders, which can complement conventional fundamental analysis and aid in recognizing potential risks and opportunities. For example, companies on the Fortune 100 Best Companies to Work For list consistently outperform the market by a factor of 3.36.²

It is precisely for all these reasons that our actively managed Thrivent Small-Mid Cap ESG ETF (TSME) seeks companies offering compelling financial returns but also a positive impact on their communities, employees and the consumers they serve. While this takes additional time and effort from our investment team, we believe the combination of an under-analyzed small-cap market, the application of ESG metrics, our expertise, time and close relationships with the companies we follow may provide the most fertile environment for adding returns over a passive small-cap fund.

Small-cap stocks have a role in a diversified portfolio

Small-cap stocks are an exciting and dynamic market that could be poised for significant outperformance. But we caution investors against trying to time their allocations. Timing the ideal entry point to capture outperformance is difficult enough. Timing both an entry and an exit probably owes more to luck than to skill. As such, we caution investors against expecting such a skill will benefit their portfolios consistently over time.

However, we encourage investors to think about the role (and size) the asset class could place in an overall strategic asset allocation. Because of the volatility of small-caps and their sensitivity to economic cycles (which are hard to time), it seems prudent to hold an allocation that is neither too aggressive nor too conservative for your particular return goals and risk tolerance.

Ultimately, we believe the most compelling advantages of investing in the market come from choosing active management over a passive exchange traded fund (ETF). While steady outperformance is never guaranteed, we believe that over the long-term incremental returns are more likely to be achieved in the small-cap market than in some of more thoroughly researched markets, such as large-caps. The compounding effect of any consistent annual boosts to return may be significant.

However, an active manager using their latitude to try to time the market is, in our view, less advantageous than one making well-researched choices among small-cap companies. In Thrivent Small-Mid Cap ESG ETF, for example, we strive to maintain an overall neutral exposure to the benchmark index to help ensure the fund is fully invested when markets suddenly surge, while looking to our stock selection to potentially drive positive incremental returns and social benefits.

¹ Thomson Reuters, “Financial materiality: Understanding the financial performance of ESG strategies,” Sept. 2022, Feb. 23, 2024.

² Great Place To Work, “When Employees Thrive, Companies Triple Their Stock Market Performance,” April 2023, Jan. 16, 2024.

Media contact: Callie Briese, 612-844-7340; [email protected]