Time to think small? Time to think small? http://www.federatedhermes.com/us/static/images/fhi/fed-hermes-logo-amp.png http://www.federatedhermes.com/us/daf\images\insights\article\magnifying-glass-forest-small.jpg November 21 2022 November 22 2022

Time to think small?

Perhaps. But the focus should be on quality.

Published November 22 2022
My Content

A tough year for equities has been even harder on small-cap stocks. No great surprise there. Because of their lack of scale relative to larger companies, smaller companies tend to be more sensitive to changes in the economy—to the upside when growth is accelerating and the downside when it’s decelerating. And because smaller companies typically carry more debt than larger companies, much of it variable, they’re inclined to be more vulnerable to changes in rates. So, in the first half of the year when real GDP contracted and the Fed embarked on its most aggressive rate-hike cycle since the early 1980s, small caps as measured by the Russell 2000 underperformed larger companies as measured by the S&P 500.

The past month, however, has seen smaller companies take the lead. Again, no great surprise. The fourth quarter got off to a relatively strong start—the Atlanta Fed currently has Q4 GDP tracking at 4.2% annualized rate, its best pace since last year. Similarly, futures suggest the Fed is closing in on an end point for its rate-hike cycle. At this writing, the yield on the 10-year Treasury is down 50 basis points from its October cycle peak of 4.25%. Stronger growth and lower rates represent tailwinds for small caps—they’ve outperformed large caps in all six of the six recoveries since 1980, often times meaningfully, Strategas Research says. After the dot.com bubble ended, for example, small caps outpaced large caps by more than 40%, cumulative, from October 2002 to October 2007.

To be sure, one month does not a trend make. There are many reasons growth could slow abruptly in the year ahead—that in fact is the consensus view of the Federated Hermes Macroeconomic Policy Committee. And while the Fed may be nearing a terminal rate, all indications are it will be in no rush to start easing. Futures currently are pricing a peak policy rate of 5.25% through summer. So, caution is merited. That’s why when we think small caps, we’re thinking quality companies that have lower debt, stronger balance sheets and a history of earnings relative to the overall small-cap universe. Since its inception on July 1, 2007, the Russell 2000 Quality Factor Index has outperformed, on a rolling 60-month basis, the broader Russell 2000 Index more than 80% of the time through Q3 2022, according to Morningstar Direct. This would suggest that, in volatile times, quality matters.

Tags Equity . Markets/Economy . Active Management .

Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

Past performance is no guarantee of future results.

Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices.

Diversification and asset allocation do not assure a profit nor protect against loss.

Gross Domestic Product (GDP) is a broad measure of the economy that measures the retail value of goods and services produced in a country.

Russell 2000® Index: Measures the performance of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately 8% of the total market capitalization of the Russell 3000 Index. Investments cannot be made directly in an index.

Russell 2000 Quality Factor Index: A composite of the broader Russell 2000 Index that focuses on constituents with a history of profitability, efficiency, earnings quality and leverage. Indexes are unmanaged and investments cannot be made in an index.

Small company stocks may be less liquid and subject to greater price volatility than large capitalization stocks.

S&P 500 Index: An unmanaged capitalization-weighted index of 500 stocks designated to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. Indexes are unmanaged and investments cannot be made in an index.

Stocks are subject to risks and fluctuate in value.

Federated Advisory Services Company