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Investing.com -- In a note to clients on Tuesday, Bank of America urged caution on small-cap stocks despite recent pullbacks, citing valuation concerns and ongoing risks for the Russell 2000.
BofA noted that the index’s forward price-to-earnings (P/E) ratio fell slightly to 15.4x in July, only 2% above its historical average.
Meanwhile, the Russell 1000’s P/E rose to 22.1x, led by mega caps, compressing the Russell 2000-to-Russell 1000 relative P/E ratio to 0.70x, the lowest since mid-2022 and about 30% below its historical norm.
However, BofA says a full 30% mean reversion “may be unlikely given deterioration in quality of the Russell 2000 vs. history,” highlighting “higher leverage & EPS volatility” and “fewer profitable companies.”
Despite this, BofA notes that “extreme relative cheapness combined with 10 years of underperformance, light positioning and secular themes (reshoring/peak globalization/US capex cycle)” suggest small caps “may outperform over the next decade.”
On fundamentals, BofA remains cautious near term due to Fed and tariff risks and still-weak earnings, though 2Q showed “some green shoots.”
The bank explained that earnings growth for the S&P 600 is “on track to turn positive” with “revisions and guidance trends” improving across market caps, but “sales trends” and “corporate sentiment” for small caps remain weaker compared to large caps.
The bank prefers mid-caps over small caps this year due to “better fundamentals, cleaner balance sheets and less tariff risk,” noting that mid-caps trade at a “14% historical premium to small caps” but that premium is “the lowest since the start of 2025.”
In small-cap sectors, Financials are still ranked in top spot, supported by strong loan growth and net interest income guidance, while Health Care, Materials, and Energy rank poorly.