The case for US small-caps

The market's increased volatility in the last six weeks of 2024 was somewhat unexpected, particularly given December's historical trend of positive performance, often referred to as the "Santa Claus rally." This period of volatility came after a strong performance by large-cap stocks over the past two years. However, small-cap stocks have trailed large-caps for eight consecutive years, a record since the inception of the Russell indices. Despite this, micro-caps performed better than small-caps in 2024, and mega-caps outperformed large-caps, with the Russell Top 50 Index rising 34.2%.

Looking ahead to 2025, increased volatility is anticipated. Historically, periods of low volatility often precede spikes, and while large-caps had a relatively quiet year, small-caps experienced more volatility. This is seen as a positive by long-term investors who view volatility as an opportunity rather than a risk.

Earnings growth prospects for US small-caps in 2025 appear strong, with consensus estimates predicting a 44% increase in EPS for the Russell 2000, compared to 15% for large-caps. This anticipated rebound follows a two-year earnings recession for small-caps, making the projection plausible.

The outlook for active US small-cap management is optimistic, driven by promising earnings prospects and attractive valuations compared to large-caps. The Russell 2000's valuation, measured by EV/EBIT, remains near its lowest levels relative to the Russell 1000 in 25 years, presenting opportunities for active managers to capitalize on robust earnings growth at favorable prices. Despite recent underperformance, confidence in the long-term potential for small-cap leadership remains strong.