Citi analysts report that although funds flowing into small-cap stocks have decreased after a summer rebound, under-the-radar stocks might perform well in the coming months.
Several factors suggest a potential rebound for small-caps, including their lower earnings performance and the possibility of Donald Trump winning the election. Small-cap stocks have a lower earnings growth threshold, making it easier for them to impress Wall Street when reporting results.
Over the next three years, small and mid-cap stocks are expected to have earnings per share growth of 2%-10%, compared to the S&P 500's anticipated EPS growth of 15%-22%. Despite the strong performance of large-cap stocks during the third-quarter earnings season, some small and mid-cap stocks or sectors with significant or comparable outperformance could be more richly rewarded by the market due to lower expectations.
The S&P 500, influenced by the so-called "Magnificent Seven" stocks, may require stronger performance and valuation upgrades to justify current price levels. Additionally, small-cap stocks could hedge risks associated with a Trump election victory. Trump's proposal to impose a 20% tariff on all imports, and 60% or higher tariffs on goods from China, positions small-caps as a traditional hedge against tariff-related risks.
Historically, small-cap stocks outperformed the broader market after Trump's unexpected 2016 victory and following the steel tariffs in his first term. Analysts noted that when economic data underperformed expectations in these scenarios, small and mid-cap stocks showed a relative performance increase.
While small-cap stocks might not be expected to gain significant strength in a Trump victory scenario, they could act as a catch-up trade due to low implicit growth expectations and currently low price levels.
Lastly, despite typically lower liquidity, the potential opportunities within small-caps make this a valuable consideration. With the outstanding performance of large-cap stocks, some investors hesitate to shift to small-cap stocks, causing liquidity to decline. However, pursuing excess returns through small caps can help manage certain risks and provide investors with a trade-off against the lower liquidity compared to large-cap stocks.
