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Small caps expected to catch up to large caps going forward: Jefferies

Published 07/08/2024, 11:42
© Reuters.

This summer has been challenging for small-cap investors as the group of stocks behind in July, a month that saw significant relative gains. Now, just three trading sessions into August, the Russell 2000 (RUT) is already nearing correction territory.

Beneath the surface, performance swings have been intense, culminating in the VIX index spiking above 30, though it has since retreated from its peak. According to Jefferies analysts historical data shows there have been 89 trading sessions since 1990 where the VIX index rose above 30.

"The good news is that more often than not, we see positive equity returns that are above average with small beating large going forward,” they said in a note.

Despite this, analysts noted that their relative valuation model remains at an extreme. Within both size segments, Growth is outperforming Value. However, they believe Value is being held back by a larger presence of Bond Proxy stocks, which typically do not rebound as strongly during recoveries.

Analysts also said that the high-yield (HY) market does not indicate a worsening backdrop.

“When we see a big pullback by the Russell 2000, one of our first checks is to look at the HY market. Yes, we have seen spreads widen by about 60bps MTD, but the gap is still well below its long-term average.”

The investment bank notes that small caps generally underperform ahead of a rate cut cycle, which aligns with the Fed's typical response to a weakening economy.

In the first half of this year, small caps trailed large caps by 12.5 percentage points, compared to the usual 2.2%. Despite a rough August, small caps are still outperforming large caps by 4.6% quarter-to-date, and three months after the first rate cut, small caps are ahead by 5.2%.

"We still think small plays catch up to large going forward, but not in a straight line," analysts concluded.

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