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Investing.com -- Despite a recent rally, Bank of America analysts believe small-cap stocks are unlikely to deliver sustained outperformance in the near term, citing structural and macroeconomic headwinds.
The Russell 2000 index has bounced 20% off its early April lows after a sharp post-"Liberation Day" sell-off, helped by reduced recession fears and progress on U.S.-China trade negotiations.
“Corporate earnings risk from tariffs has been reduced,” BofA wrote, with the estimated hit to S&P 500 operating income falling to about 6% from 20%.
For small caps, they note that the risk is still 16%, but that it is an improvement from a potential 90%+ hit under more severe tariff scenarios.
Still, BofA warned that “sustained outperformance [is] not likely yet.”
Even before tariff relief, the bank was cautious on small caps, citing “higher-for-longer interest rates, low likelihood of Fed cuts amid sticky inflation, and challenged fundamentals.”
Analysts noted that small caps “are still struggling to emerge from their EPS recession,” with weak first-quarter guidance and deteriorating corporate sentiment.
While small caps often outperform when revisions bottom or recover from downturns, BofA’s U.S. Regime Indicator “just re-entered ‘Downturn,’” and earnings per share cuts have accelerated.
In contrast, the bank said mid-caps have outperformed both year to date and during the recent rebound, prompting BofA to favor stock selection over indices, especially within quality, inexpensive SMID names with positive revisions or strong margins.
BofA highlights that valuations for small caps have returned to historical averages, with the Russell 2000’s forward P/E now at 15.2x.
Although long-run projections suggest stronger returns for small caps, BofA said Financials and Utilities are currently the most attractive SMID sectors, while Energy and Materials remain the weakest. Tech and Staples are said to rank lowest in mid-caps.