Are valuation, earnings, and volatility the formula for US small-cap success?

The recent years have been challenging for small-cap stocks, which have underperformed compared to their large-cap counterparts. Historically, small-caps have offered higher long-term returns with greater volatility, but this advantage has diminished. The current period of large-cap dominance, particularly by mega-cap stocks, has persisted since 2011. Despite this, small-cap stocks now present attractive valuations, with their lowest relative valuation versus large-caps in over 25 years, suggesting potential for a reversal in performance trends.

The valuation disparities are evident across all sectors, indicating that opportunities exist within the small-cap universe, particularly in sectors like information technology, industrials, and consumer discretionary. While valuations are appealing, the key driver for small-cap performance will be earnings growth. The Russell 2000 is expected to see significant earnings growth in 2025, rebounding from a two-year earnings recession, with consensus estimates predicting an 89.3% EPS growth compared to 30.9% for the Russell 1000.

Despite recent underperformance, historical patterns suggest that small-caps could see substantial returns following low-return periods. The current market environment, characterized by volatility and uncertainty, may offer opportunities for active investors to capitalize on mispriced assets. The rise in the VVIX, a measure of volatility of the VIX, indicates increased market uncertainty, which could benefit long-term small-cap investors who focus on fundamental business values. As we progress into 2025, the outlook for small-cap stocks appears promising, supported by favorable valuations and potential earnings growth.