The prospects for extended US small-cap outperformance

The Russell 2000 Index experienced a notable rebound in 3Q24, attributed to a reversion to the mean, as small-caps had been underperforming larger companies for an extended period. Despite a volatile quarter, with gains concentrated in early July, the index outperformed larger indices, indicating a potential shift in market dynamics. Volatility, while challenging in the short term, is seen as an opportunity for strategic positioning, particularly in small-cap investments where intra-year fluctuations are common.

The potential for sustained small-cap leadership is linked to the broadening of large-cap market breadth, which historically favors small-cap performance. Earnings growth is crucial for maintaining long-term small-cap outperformance, despite a high percentage of Russell 2000 companies currently lacking earnings. High returns on invested capital (ROIC) are emphasized as indicators of company quality, guiding investment strategies focused on long-term value compounding.

Falling interest rates are less impactful than rate normalization, though they may spur increased M&A activity, benefiting small-cap stocks. Historically, small-caps have performed well post-election, regardless of the winning party, suggesting that market stability post-election is more influential than political outcomes. Investment themes in small-cap stocks typically emerge from individual company analysis rather than predetermined themes.

The outlook for small-cap stocks is cautiously optimistic, with concerns over geopolitical tensions and domestic challenges balanced by moderating inflation, economic growth, and normalized rates. The current market environment presents an opportunity for investors to increase small-cap allocations at attractive valuations, with historical trends suggesting potential for strong future performance following periods of underperformance.