Are small and mid-cap stocks the hidden gems of the stock market? Their attractive valuation and potential for next cycle leadership prove they might be.
Madison Faller, Global Investment Strategist
Christopher Baggini, Global Head of Equity Strategy for J.P. Morgan Wealth Management
Olivia Schwern, Global Investment Strategist
Our Top Market Takeaways for March 3, 2023.
Market update
It’s getting warmer
…and the slew of strong data of late (from manufacturing to inflation, consumption and jobs) has been too hot for markets to handle.
Bond yields have gone on another tear higher—2-year Treasury yields breached 4.9% for the first time since 2007, and the 10-year is back above 4% for the first time in four months. February’s surge was the largest monthly jump since September. Bonds are back on the menu, and the latest moves give investors another chance to bite.
And while higher rates have prompted stocks’ weakness over the last three weeks, the S&P 500 is sitting at the same level (3,981) it was in May 2022, when the Federal reserve was expected to only hike to 3%. Stocks are holding up pretty well, considering 10-year Treasury yields have jolted over 100 basis points since then and markets are now pricing Fed policy rates to get to 5.5%.
Stocks outside the United States are holding up even better. Core Eurozone inflation hit another record yesterday, and the Stoxx Europe 600, which includes companies listed across the region, still finished the day in the green and is sitting at levels prior to Russia’s invasion of Ukraine.
Chinese stocks are also catching another bid as reopening boosts growth. February’s PMI data (one of our favorite leading growth indicators) just smashed expectations across the board, with manufacturing activity expanding at its fastest pace in over a decade.
All that’s to say, U.S. large-cap stocks are holding up, but they may not be the only game in town. We continue to scour the market for pockets of opportunity that offer compelling valuations and growth. Within the United States, small- and mid-cap stocks might be hidden gems, and today we share why we think investors should consider building exposure.
Spotlight
Broadening horizons: Looking to SMID-cap stocks
You would never shop in only one aisle of the supermarket, would you? Unfortunately, many investors do just that when it comes to their portfolios—by, for example, sticking to their home country markets, or to just familiar large companies. Failing to broaden horizons or adapt to the changing tide could leave future returns on the table, especially in a shifting economic environment like this one.
We believe the opportunity is ripe today for smaller and medium-sized companies, for three big reasons:
1. Believe it or not: Small- and mid-cap stocks have outperformed large-cap companies over the last 25 years.
We all tend to suffer from a bit of recency bias—we expect what happened in the past to repeat. Big tech galvanized large-cap stock returns over the last decade, earning a whopping ~160% price return since then. Yet, a look at returns over the last 25 years shows us that smaller companies have actually outgrown and outperformed larger firms.
All that’s to say, the large-cap outperformance over the last few years may be the exception, not the rule.
Large cap outperformance: The exception or the rule?
These line charts show the returns of large-cap (S&P 500), mid-cap (S&P 400) and small-cap (Russell 2000) equity returns over the past 10 and 25 years. The top chart looks at returns from 2013. Each of the indices tracked each other quite closely between January 2013 and September 2018, with the three market caps returning roughly 90%. From here, there is a pullback. Large caps returned 55% by December, then rose to 123% by February 2020. They dropped to 47% by March 2020, then rose sharply to 215% by January 2022. Returns then dipped and landed at 162% through March 2023. Meanwhile, mid caps fell to 42% by December 2018, rose to 92% by February 2020 and fell to 11% by March 2020. They then rallied to 165% by November 2021, dipped, then rose back to 139% through March 2023. Finally, small caps dipped to 39% in December 2018, rose to 85% by February 2020 and fell to less than 10% by March 2020. They then rose sharply to 167% by November 2021, dipped, then ended at 108% through March 2023. The bottom chart looks at returns since 1998. Large caps returned 40% by August 2000, -22% by March 2003, up to 18% by July 2008, then dipped to -35% by March 2009. They then rallied to 220% by February 2020. They fell to 130% by March 2020 and rallied to 360% by January 2022. They dipped, then ended March 2023 returning 278%. Meanwhile, small caps followed a similar trend, returning 75% by September 2007, -25% by March 2009, 180% by June 2015, 265% by February 2020, dipped to 115% by March 2020. They then rose sharply to 425% by November 2021 and dipped, then rose again to end 2023 at 310%. Finally, mid caps returned 110% by March 2008, dipped to 14% by 2009, then rose sharply to 494% by February 2020. They then fell to 243% by March 2020, rose to 720% by November 2021, then dipped and rose back to 639% through March 2023.
2. It’s so bad, it’s good. We think valuations and earnings estimates have bottomed—cue entry point.
Over the last year, across all market capitalization ranges, estimates for corporate profits have plunged over 10%—but the largest declines have been in small-cap equities, and the pain has been so acute, we’re starting to see a bounce higher. What’s more, valuations for both small- and mid-cap companies have corrected to levels we usually see during recessions (while large-cap valuations are still in line with their long-term averages).
SMID cap valuations look attractive
This chart shows small- and mid-cap price-to-earnings ratios relative to large-cap equities from 1998 to 2023. Small caps began at 0.75, and rose to 1.4 by July 2002 and 2.1 by August 2009. They then dipped back to 1.1 by November 2012 and rose to 1.6 by April 2015. They fell to 1.1 again by March 2020 before spiking above 2.5 by July 2020. They then fell back to 1 by May 2022 and rose to 1.2 by March 2023. The average over that time period was 1.3.
Meanwhile, mid caps also began at 0.75 and rose steadily to 1.2 by May 2006. They then dipped to 0.9 by November 2008 and rose to 1.3 by May 2011. They steadily fell to 0.7 by May 2022 and rose to 0.8 by March 2023. The average over that time period was 1.
3. The leaders of the next cycle likely won’t be the same as the last—and SMID-cap companies could take the baton.
In the past cycle, growth was synonymous with tech, buoyed by ultra-low interest rates. Looking forward, it’s hard to see mega-cap tech companies maintaining their pace of growth, especially as key markets become more fully penetrated and valuations still look pretty stretched. On the other hand, SMID-cap companies look poised to benefit from increased capital markets activity, a new era of capex spending focused on the real economy (thanks to a greater weighting toward sectors such as industrials, materials and real estate), and the ongoing push to bolster supply chains amid geopolitical tensions (as companies seek to onshore their production).
Investment considerations
Get active
In the end, we believe large-cap stocks are the most important drivers of capital appreciation for investors over the long term. But right now, there is more to the market than just the biggest companies. As cycles turn, small- and mid-cap companies tend to outperform as growth reaccelerates, and we think now is the time to start getting exposure.
Small cap stocks tend to outperform just following recession
This chart shows the small-cap equity performance (represented by the Russell 2000 Index) relative to large caps (S&P 500) through the past six recessions, and the relative performance in the first year of the recovery. Finally, there is an average of the instances. • 1980: Small caps underperformed through recession by 10%, and outperformed in first year of recovery by 31% • 1982: -9%, 28% • 1990: -11%, 14% • 2002: 3%, 25% • 2007: -4%, 25% • 2020: -8%, 43% • Average: -6%, 28%
But this part of the market is not without its risks—SMID-cap stocks tend to be more volatile and hold more debt. In this space, it’s prudent to engage with active managers with proven expertise in selecting quality businesses that have flush balance sheets and which are best suited to the trends of tomorrow.
Your J.P. Morgan team is here to help you discuss this potential opportunity in the context of your goals.
All market and economic data as of March 2023 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.
We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice
RISK CONSIDERATIONS
- Past performance is not indicative of future results. You may not invest directly in an index.
- The prices and rates of return are indicative, as they may vary over time based on market conditions.
- Additional risk considerations exist for all strategies.
- The information provided herein is not intended as a recommendation of or an offer or solicitation to purchase or sell any investment product or service.
- Opinions expressed herein may differ from the opinions expressed by other areas of J.P. Morgan. This material should not be regarded as investment research or a J.P. Morgan investment research report
