Jefferies Predicts Small Caps Will Catch Up to Large Caps Moving Forward

This summer has posed challenges for small-cap investors, particularly as this sector lagged behind in July, a month marked by notable gains elsewhere. Now, just three trading sessions into August, the Russell 2000 Index is approaching correction territory.

Performance fluctuations have been pronounced, peaking with the VIX index rising above 30 before it retreated. Historical data from Jefferies reveals that since 1990, there have been 89 trading sessions where the VIX exceeded this level.

The analysts note that there is some positive news, as historically, positive equity returns tend to be above average after such peaks, with small-cap stocks outperforming large-caps in the following periods.

However, despite this potential for recovery, the analysts indicated that their relative valuation model is currently at an extreme. Within different size categories, Growth stocks are outperforming Value stocks; they suggest that the latter is hindered by a higher concentration of Bond Proxy stocks which generally have weaker rebounds during recovery phases.

Additionally, the high-yield market does not suggest an deteriorating economic environment. Analysts pointed out that during a significant pullback in the Russell 2000, they closely monitor the high-yield market. They noted that while spreads have widened by approximately 60 basis points this month, they still remain beneath the historical average.

The investment bank observes that small-cap stocks typically underperform leading up to a rate cut, which aligns with the Federal Reserve’s usual strategy in response to a slowing economy.

In the first half of the year, small-cap stocks lagged behind large-cap stocks by 12.5 percentage points, a significant difference compared to the typical 2.2% lag. Despite the challenging conditions in August, small-caps have managed to outperform large-caps by 4.6% thus far in the quarter. Historically, three months following the first rate cut, small-caps tend to lead by 5.2%.

Analysts remain optimistic, asserting that while small-cap stocks are expected to catch up to their larger counterparts over time, the path is unlikely to be linear.