Small-Cap Stocks Have Gotten Crushed. Their Rebound Could Be Swift.

Text size

Small-company stocks have gotten hit hard—harder than their larger peers. That means small-caps could face less risk if the market continues to fall and more upside once it starts to turn.

While the

S&P 500
has fallen 23.4% from its January all-time high, the small-cap

Russell 2000
has dropped 31.8% from its own record, which it set in November. That makes sense given that everything making large-cap stocks fall—high inflation, the Fed’s interest-rate increases, and recession fears among them—hit small companies harder. But it also means that once investors stop worrying and look ahead to better times, small-caps could outperform.

Make no mistake—the pain in small-cap stocks has been acute. The Russell 2000 has fallen 26% in 2022, on pace for its worst first-half performance on record. The worst before now was in 2020, when the Russell fell 13%, and then 1982, when it dropped 11%, and 1984, when it fell 9.5%. The index followed up with a much better second half in all three cases, gaining 38% during the last six months of 2020, 40% in 1982, and 2.4% in 1984. “Worst 1st half ever for small-caps, tends to mean better 2nd half,” writes Jefferies strategist Steven DeSanctis.

This time, the Russell’s drop has been far more severe than the S&P 500’s and has created a “relative oversold” condition, says John Roque, head of technical strategy at 22V Research. That should help small-caps bounce back faster than large-caps.

This year’s drop has also squeezed the Russell 2000’s valuation far more than the S&P 500’s. The

iShares Russell 2000
exchange-traded fund (ticker: IWM), which tracks the index, trades at 15.8 times 12-month forward earnings, down 10.6 points from its November peak of 26.4. The S&P 500 has seen its price/earnings multiple fall to 15.4, down six percentage points from its January peak of 21.4. The Russell’s valuation is now less than half a percentage point above that of the S&P 500. But the gap is usually about five points, implying that there’s more upside ahead for small-caps, even if there’s a recession ahead.

But if the economy avoids a recession, small-caps look particularly attractive. Analysts expect aggregate earnings per share in 2023 for the Russell 2000 ETF to grow 20% year over year, according to FactSet. That’s more than double the S&P 500’s expected EPS growth. Even if the ETF trades at its current multiple, it would gain about 27% from here simply from earnings growth.

“If you don’t think we’re going into recession in the next 12 months, and small-caps have more attractive earnings estimates and are selling at a discount, you should buy them all day long,” says Jonathan Golub, chief U.S. equity strategist at Credit Suisse.

That makes sense, even if it sounds like wishful thinking right about now.

Write to Jacob Sonenshine at [email protected]