US Small Caps are Trading at a Historic Discount; Can they Rebound in 2024?
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US Small Caps are Trading at a Historic Discount; Can they Rebound in 2024?

Small-cap stocks are currently sitting at substantial discounts and are likely to be poised for a rebound in 2024.
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The S&P 500 staged an impressive rebound in 2023, but its better-than-expected performance is largely attributed to the biggest US stocks. Meanwhile, small-cap stocks have underperformed their giant peers due to higher interest rates. With a recent dovish pivot by the Federal Reserve, small-cap stocks are trading at notable discounts, and next year could be their time to shine. 

Small-cap Stocks Trading at a 30% Discount

Small-cap stocks have witnessed a massive spike over the past week, with the Russell 2000 index surging more than 6.3% since the Fed confirmed its plans for a dovish pivot in 2024.

The surge propelled Russell 2000 – a market index that tracks 2,000 small-cap US-listed stocks – near its 2023 peak of $2,000 on Thursday before witnessing a pullback. Still, despite recent surges, the index is up only 13% year-to-date, underperforming the 24% gained by the S&P 500.

The reason behind its underperformance is that the bulk of gains seen by the broader stock market this year were fueled by the Magnificent Seven, the world’s biggest tech company. 

As a result of this discrepancy, market strategists believe small-cap stocks are currently trading at very appealing valuations. Despite their significant gains in recent weeks, small-cap equities are sitting at a 30% discount to their large-cap peers based on analysts’ projections for corporate earnings in 2024, said Michael Wilson, Morgan Stanley’s top equity strategist. 

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Are Small-Cap Stocks Positioned for a Rally in 2024?

The Fed’s recently announced dovish pivot made a massive impact. Although investors hoped the central bank would begin cutting rates next year, the official confirmation brought a fresh wave of optimism. 

As such, if the Fed successfully orchestrates the much-discussed “soft landing” for the US economy, small-cap stocks and other underperformers could be poised for a considerable rebound. As mentioned earlier, the Fed’s switch to a dovish stance will be the primary catalyst if that happens.

Small-cap stocks are typically more sensitive to interest rate changes and gloomy economic outlooks, and given that rates are sitting at 22-year highs, their underperformance so far is hardly surprising. 

Following the “everything rally” that began in early November, their day in the sun may be on the horizon. 

“If inflation stabilizes at a higher level, small-caps/cyclicals/lower quality stocks could be beneficiaries. Of course, this is a fine line with inflation statistics still running above target. Should these numbers start to rise again, the Fed could reverse course. Right now though, we could be entering a sweet spot that supports this rotation if nominal growth accelerates.”

– said Wilson.

Tom Lee, former JPMorgan’s chief equity strategist and co-founder of Fundstrat Global Advisors, shares this sentiment. The veteran analyst, bullish on the S&P 500’s performance in early 2023, said investors should look to smaller companies for outperformance in 2024. 

“In the next 12 months it seems like small-caps can be up 50%,” he told CNBC Friday. The strategist added this bull run could take the Russell 2000 index to a whopping 3,000 by year-end.

Lee, convinced that inflation is now under control, said small-caps had been hit the hardest by substantial borrowing costs, arguing that an expected shift in monetary policy should be a boon for these assets. 

Do you agree with analysts’ views that small-caps could witness significant interest next year? Let us know in the comments below.