A Tip of the Cap…to Small Caps

During the coronavirus pandemic, small-capitalization stocks have become a big deal. Below, I explain why small caps make sense in 2021. I also show which sectors should perform best.

Since the stock market’s pandemic-induced trough a year ago on March 23, 2020, the small-cap benchmark Russell 2000 Index has gained about 124%, compared to about 70% for the SPDR S&P 500 ETF Trust (SPY) during the same time frame (as of market close March 22, 2021). Conditions are ripe for small caps to continue beating the broader market this year, which bodes well for the rally because their ascent confers greater breadth.

As spring gets underway, rejuvenation is in the air. President Biden recently asserted that there will be enough vaccine shots for all American adults by the end of May, two months earlier than expected. The White House also is preparing a $3 trillion infrastructure bill, on top of the $1.9 trillion relief package Biden already signed this month.

Wall Street is encouraged by the prospect of more fiscal stimulus. On Monday all three main U.S. stock market benchmarks rose: the Dow Jones Industrial Average by 103.23 points (+0.32%), the S&P 500 by 27.49 points (+0.70%), and the tech-heavy NASDAQ by 162.31 points (+1.23%). In pre-market futures trading Tuesday, stocks were taking a breather.

The Biden regime’s attitude with fiscal stimulus is, go big or go home. For investors my mantra is, go small (cap) or go home.

Watch This Video: The Bull Case for 2021

With the end of Q1 2021 approaching, analysts are increasingly optimistic in terms of issuing Buy ratings on stocks in the S&P 500 heading into the second quarter.

Overall, there are 10,374 ratings on stocks in the S&P 500, among which 54.9% are Buy ratings, 38.2% are Hold ratings, and 6.9% are Sell ratings (as of March 19, according to research firm FactSet).

At the sector level, analysts are most optimistic about health care, information technology, and energy. Each sector earned 61% Buy ratings, as the following chart shows.

Health care has gained greater impetus due to the demands of the coronavirus pandemic; information technology continues to benefit from the past year’s socio-economic transformation to a work-at-home culture; and energy prices are rising as demand rebounds amid economic reopening.

The estimated year-over-year earnings growth rate on average for the S&P 500 in Q1 2021 is 22.6%, which is above the five-year average earnings growth rate of 3.8%. The estimated year-over-year revenue growth rate for Q1 is 6.2%, which is above the five-year average revenue growth rate of 3.5%.

If 22.6% is the actual earnings growth rate for the quarter, it will mark the highest year-over-year earnings growth reported by the index since Q3 2018 (26.1%). Eight sectors are projected to report year-over-year earnings growth, led by the consumer discretionary, financials, and materials sectors. Three sectors are projected to report a year-over-year decline in earnings, led by the energy and industrials sectors.

Analysts expect double-digit earnings growth for all four quarters of 2021. At the same time, the U.S. economic recovery is accelerating at a torrid pace. Economic growth in the first quarter is estimated to come in at 5.7%, according to new projections from the Federal Reserve Bank of Atlanta.

Leading the charge…

As economic and earnings growth pick up steam, we’re seeing small-cap stocks gain in popularity. Small-cap stocks are generally defined as having market valuations of between $300 million and $2 billion.

Small-cap stocks get a bad rap for volatility. But the right company can deliver impressive gains without taking investors on a roller coaster ride. Over the long haul, small-caps have outperformed their larger brethren.

Investors often regard small-cap stocks as speculative fare, prompting many to eschew what they perceive as a higher-risk segment of the market. In reality, the small-cap universe comprises its fair share of growth names from rock-solid balance sheets.

It’s a lot easier for, say, a $1 billion company to become a $10 billion one than it is for a $100 billion company to grow to $1 trillion.

That’s not to suggest that small-caps don’t entail some risk. But small-cap exposure has helped investors boost portfolio returns. Small-cap stocks perform particularly well immediately after the market bottoms in a recession, as demonstrated by the past 12 months of small-cap outperformance.

During the COVID-19 economic downturn, many investors steered clear of small-cap names, blinded by the illusion that smaller firms lacked the resources to weather the storm. Investors who saw beyond this misconception and put their money into small caps reaped the benefits.

The rally continues but we’re in the midst of a market rotation toward value, small caps, and cyclicals. Recalibrate your portfolio accordingly.

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John Persinos is the editorial director of Investing Daily. You can reach John at: mailbag@investingdaily.com. To subscribe to his video channel, follow this link.