Can small-cap value keep it going?

It’s been an “on the one hand/on the other” type of market so far this year, with strong jobs growth, record-low unemployment and resilient consumers and services pitted against flagging corporate earnings, persistent inflation and a hawkish Federal Reserve that seemingly has more reasons to stay that way. Amid these crosscurrents, small-cap value equity has had an unlikely run. Here are three reasons why there may still be room for further gains in this historically overlooked corner of the market.

Attractive valuations Even with their recent run—up 15% off their late September low despite some giveback this month, according to the Russell 2000 Value Index—small-cap value stocks are trading at a significant discount relative to bigger stocks. Their weighted average P/E is just shy of 14x, barely half that of the broader large-cap market, and well short of small-caps’ historical average. The asset class has a lot of ground to make up relative to growth stocks, whose multiyear run was abetted by record-low interest rates that don’t look to be coming back anytime soon. Data going back to the 1970s shows periods of relative underperformance for small value tend to be followed by periods of outperformance, suggesting we could be witnessing the beginning of the next value cycle.

Peak inflation While the downward trend has moderated of late, inflation appears to have topped out last summer, when nominal CPI hit 9.1% year-over-year in June, up from just 1.4% at the start of 2021. It has since fallen to 6.4% year-over-year, still elevated but well off its highs. Forward-looking data suggest the disinflationary trend will be choppy—wages and housing, two big components, tend to be sticky and remain near highs, meaning the Fed is likely to keep rates higher for longer. How much higher is a matter of debate, but clearly after 450 basis points of policy rate increases, policymakers are closing in on the end of the cycle. Historically, small-cap stocks have tended to outperform relative to other equity classes during periods in which inflation was receding from its peak.

No one wants a recession but... Consensus keeps shifting on whether the economy is headed for recession. But there does appear to be widespread agreement that growth is more likely to slow than accelerate in the year ahead, particularly as the lagged effects from biggest increases in policy rates in more than 40 years takes hold. Small-cap value stocks outperformed small-cap growth, large-cap growth and large-cap value on a one-year total return basis after each of the last five recessions (with the partial exception of the Covid recession, which led to small-cap growth outperforming small-cap value amid unique market conditions). A key reason is that the small-cap value space is populated by more cyclical companies than other equity styles, including the Industrials, Financials, Materials and Consumer Discretionary sectors that usually are the earliest beneficiaries when economic conditions trough and begin to turn positive.

In this uncertain and volatile market environment, the bottom line is that valuations, receding inflation and the potential for post-recession upside make small-cap value an asset class that long-term investors should consider.