We are in a bear market for equities and the economy is likely to slip into recession. While this backdrop is ominous it also spells opportunity for longer term investors. Historically market downturns have been a great time to pick up stocks on the cheap.
We think small cap stocks represent an interesting opportunity for longer term investors.
Our first consideration is positioning for the next phase in the market cycle. As mentioned we are in a bear market, which is followed by the start of the next bull market.
Generally the most attractive phase of the bull market cycle is early in the cycle, where on average it captured 41% of the whole bull market return.
We have done a lot of work on market cycles to help determine how different asset classes have historically performed in each phase.
Note how Small caps tend to lead the market out of a downturn and often that performance even extends into the mid cycle.
The next consideration is valuation.
This chart is a histogram looking at historical monthly P/E observations for the S&P 600 index. Along the bottom are the P/E buckets with low P/Es on the left and high P/Es on the right, and then the height of the bars represent the number of monthly observations for each bucket. As you can see we are in a rarified place right now. This is also true of other valuation measures like P/CF and EV/EBITDA. It is also notable that Small caps are trading at a discount to large caps, which is also quite rare, as they typically sell at a premium.
On the other hand it is important to note that small cap companies are much more economically sensitive and the Fed is set on slowing this economy. So there is certainly earnings risk, but that is also true for large caps, and small cap investors are getting better compensated for that risk in terms of valuation.
Some other factors to consider – smaller caps have much less international exposure relative to large caps meaning the strong dollar is less of a headwind. They might also benefit more from easing supply chain conditions as smaller companies likely had less bargaining power during the pandemic.
On the other hand smaller companies may be more impacted by tighter credit conditions, though it is notable that small caps have seen a dramatic improvement in their leverage ratio.
So when we put it all together we see an opportunity for longer term investors who want to take advantage of this bear market and add some stocks on the cheap that may be positioned to outperform in the rebound. And we believe that opportunity is in smaller cap stocks.
Equities are subject to market volatility and loss. Investing in stocks of small-cap companies, may be subject to more erratic market movements than stocks of larger, more established companies.
This commentary is for informational purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy or a recommendation to buy, sell or hold any security. Investing in an index is not possible. Investing involves risk, including the possible loss of principal and fluctuation of value. Past performance is no guarantee of future results.
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