Author: David I. Templeton, CFA, Principal and Chief Investment Officer
I have written articles on this blog over the past year or year and a half about small company stocks beginning to receive investor attention as they began to outperform large company stocks. The small cap outperformance tended to be short lived though as investors turned their attention back to the so-called Magnificent 7 or 8 mega cap technology stocks and more broadly large company stocks. Of late though, small cap stocks are once again leading many other asset classes. As the below table shows and sorted on the 3-month total return column, the leading asset classes are micro-cap, small cap and mid cap stocks. The iShares S&P Small Cap 600 ETF (IJR) is up 9.68% versus the S&P 500 Index up 5.0% over the past three months.
Another small company stock index is the Russell 2000 Index and is investable by using the Russell 2000 ETF (IWM). This ETF is now outperforming the large cap S&P 500 ETF (SPY) on a 1-year basis, 19.52% versus 18.14%, respectively. A difference between the S&P 600 Index and the Russell 2000 Index, both focusing on small companies, is the S&P 600 Index requires that companies comprising the index to be profitable. However, this profitability requirement is not a metric for the Russell 2000 Index and a little more than 40% of the companies in this index are unprofitable.
A question investors ask is whether this outperforming trend for small caps is sustainable and there are some underlying factors that suggest maybe it is. Because a large percentage of small cap companies are unprofitable, they tend to carry more debt financing on their balance sheet to operate the business. With the Fed lowering interest rates, and expected to continue to do so this year, debt financing cost becomes less burdensome for companies using debt. Additionally, as seen in the below table from LSEG I/B/E/S, earnings growth for small companies is expected to be significantly positive through the third quarter of 2027.
Certainly, this outperformance with small cap stocks might be fleeting; however, some underlying factors like lower interest rates and strong earnings growth seem to suggest otherwise. Up until recently momentum has favored the Mag 7 or 8 stocks, but as seen in the below chart all but two are underperforming the S&P 500 Index over the last three months. In short, this rotation into other asset classes would make the equity market rally sustainable through 2026, of course not higher in a straight line.
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