market strategist David Sekera says that with the economy likely to slow in the coming year, “small- and even mid-cap stocks will have a difficult time performing until the market begins to price in the economic rebound. For that reason, investors may want to stick with “stronger balance sheets and higher-quality large caps” until there’s more clarity on how the economy will land. “The environment is going to get a little bit tougher,” says Jeffrey Buchbinder, chief equity strategist at LPL Financial. That means more uncertainty for small-cap stocks. And it isn’t clear exactly when it may happen, though analysts generally agree that economic growth will slow in the coming months. Small-cap stocks are also more sensitive to economic cycles compared with larger-cap ones, for many of the same reasons they’re more sensitive to interest rates.Ī slowing economy is “not particularly favorable for small caps,” Clissold says, as they tend to outperform at the beginning of a bull market or economic expansion.Įconomists have been warning of a recession for months, but so far it hasn’t happened yet. Watch: Fed Focused on Higher for Longer, But Rate Cut Talk Likely Coming A Slowing Economy Could Keep Small Caps Down In fact, Clissold says, interest expenses for small-cap stocks are currently at a record high. Higher borrowing costs mean more expenses, and that takes a toll on earnings and profits. Right now, borrowing conditions are far from favorable. As a result, small caps are more sensitive to interest rates than large caps. That means smaller companies usually must borrow more often to grow, and they tend to be the first firms to get less favorable conditions for that debt. One reason is that they’re generally more dependent on capital markets than their bigger and more stable counterparts, which tend to have more cash on their balance sheets, Clissold explains. As William Blair macro analyst Richard de Chazal put it recently: “Smaller caps can generally be viewed as the speedboats of the equity world, compared to the larger-cap supertankers.” That phenomenon is eventually true for all types of stocks, but it happens much more quickly for smaller ones. The Fed’s “higher for longer” strategy has been a factor in small-cap underperformance because it makes these stocks’ balance sheets less attractive to investors, Coleman says. Those hikes are designed to prevent a recession, but they also take a toll on stocks. Source: Federal Reserve Economic Database. Historical Price/Fair Value Distribution of Small-Cap Stocks The further away from 1.00, the more over- or undervalued the asset. Ratios over 1.00 indicate a stock is overvalued, while ratios below 1.00 mean it’s undervalued. This means stocks in the small-cap index are relatively cheaper than their larger counterparts. Today, stocks in the Small Cap Index carry an average price/fair value estimate ratio of 0.78, while the average stock in the Morningstar US Large Cap Index has a ratio of 0.93. Plus, many aren’t profitable or are more reliant on debt compared with their larger counterparts. They’re more sensitive to changes in interest rates and the economy, and more volatile as a result. Investors like them because they tend to offer lots of growth potential, unlike larger, more established companies. Morningstar defines small-cap stocks as those in the bottom 10% of the stock market by capitalization. “Right now, they appear to be cheap for a reason.” strategist at Ned Davis Research, by some measures, “small caps are trading at near their steepest discount on record.” But just because a stock is cheap doesn’t mean it’s a good buy.