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3 Reasons to Stay Cautious on Small Caps

Oct 23, 2024

Some investors expect a favorable economy and falling rates to spur a long-awaited rally in smaller stocks. Here are three reasons for caution.

Author
Lisa Shalett
Lisa Shalett

Key Takeaways

  • Economic soft spots such as a contracting manufacturing sector and a frozen housing market pose challenges to small-cap stocks.
  • Small business hiring and spending intentions remain weak amid uncertainty about government policy and higher borrowing costs.
  • The overall quality of publicly traded small caps has deteriorated, as private sponsors help top performers stay private for longer. 
  • Instead of small caps, investors should consider actively adding exposure to U.S. large-cap value and mid-cap growth stocks.

U.S. stocks have seen broad-based gains over the last month, thanks to investors’ enthusiasm around a successful economic “soft landing,” in which inflation cools and growth remains robust. Money has flowed out of the so-called Magnificent 7 tech stocks and toward other, value-oriented and economically sensitive “cyclical” equities such as financials and industrials.

 

Given the favorable backdrop and the U.S. Federal Reserve’s interest rate cuts, investors are also asking if it’s finally time to embrace small-capitalization equities (commonly defined as companies whose market value is between $250 million and $2 billion). After underperforming for most of the past three years, these stocks look relatively cheap and, in theory, should benefit most from lower borrowing costs, given their greater reliance on external financing and floating-rate debt.

 

However, Morgan Stanley’s Global Investment Committee is less convinced that small caps are compelling investments currently. We suggest long-term investors avoid them for now, for at least three reasons. 

Wealth Management

Bifurcation

With the Fed now on its easing path and market performance broadening, is it finally time to embrace small-cap stocks? Here’s why caution is still warranted.

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  1. 1
    Economic Soft Spots Challenge Small Caps

    To be sure, the overall economic picture looks encouraging. Unemployment claims are still relatively benign, retail sales have beat analysts’ estimates, and the Atlanta Fed’s GDPNow model suggests real growth of 3.4% in the third quarter of 2024.

     

    But the aggregate picture doesn’t tell the whole story. Under the surface, U.S. manufacturing has been in contraction for 24 months, and the housing market is frozen, constrained by a massive supply-demand imbalance, lack of affordability and an existing housing stock that is dominated by properties mortgaged at rates well below those currently available to prospective home buyers. The equity sectors likely to be more adversely affected by such challenges include industrials, consumer discretionary and financials, which make up some of the largest portions of the small-cap Russell 2000 Index.

     

    What’s more, small-cap financial firms may feel the impact of the growing disparity between the wealthiest households and the mid- and low-income households: The top two quintiles of wealth have grown their share of total consumer spending from roughly 50% pre-COVID to 65% today. Meanwhile, the lower-income cohorts have depleted their excess savings, run up credit-card balances and are increasingly delinquent on mortgages, auto loans and credit cards. These factors may not threaten the largest, systemically important banks, which have the scale and diversification in their business lines and customer bases to weather such challenges; however, they are sure to create headwinds for many small-cap financial firms.  

  2. 2
    Uncertainty and Higher Rates Weigh on Outlook

    Small-business sentiment, according to the National Federation of Independent Business (NFIB), has been weakening pretty consistently since 2022, while uncertainty about government policy has hit the highest reading on record. Small businesses’ hiring and capital-spending intentions have also remained very weak, as their average short-term borrowing rate has reached about 10%—more than two-and-a-half times the average cost of capital for companies in the S&P 500.

  3. 3
    Quality Wanes As Private Capital Beckons

    A final factor to consider is relative quality. In recent years, the S&P 500 Index has materially improved in quality, growth characteristics and resilience. The small-cap universe, on the other hand, has weakened. On a trailing 12-month basis, for instance, almost 45% of companies in the Russell 2000 are unprofitable. By one measure, Russell 2000 company earnings have been falling since 2021.

     

    What happened? Many small companies may simply be struggling to stay competitive in a world increasingly driven by technology investment and scale. Also, financial sponsorship from private equity is allowing many of the most promising small companies to stay private for longer and achieve greater scale before they go public, if they do. This leaves investors choosing from the available crop of publicly traded small caps at a disadvantage. 

Portfolio Moves to Consider

 While some investors believe economic growth and falling rates will bolster small caps, we note that this is not a typical economic cycle, and small caps are not the asset class they used to be. We see notable skews in the underlying data that create a more nuanced and less certain outlook, which calls into question whether the rising tide can lift all boats. 

 

Considering all of these issues, we think long-term investors should avoid small caps for now. Meanwhile, consider adding exposure to U.S. large-cap value and mid-cap growth stocks, pursuing an active approach in line with an uneven soft landing.

 

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from October 21, 2024, “Bifurcation.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.

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Risk Considerations

Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.

Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.

Investing in smaller companies involves greater risks not associated with investing in more established companies, such as business risk, significant stock price fluctuations and illiquidity.

Stocks of medium-sized companies entail special risks, such as limited product lines, markets, and financial resources, and greater market volatility than securities of larger, more-established companies.

Value investing does not guarantee a profit or eliminate risk. Not all companies whose stocks are considered to be value stocks are able to turn their business around or successfully employ corrective strategies which would result in stock prices that do not rise as initially expected.

Growth investing does not guarantee a profit or eliminate risk. The stocks of these companies can have relatively high valuations. Because of these high valuations, an investment in a growth stock can be more risky than an investment in a company with more modest growth expectations.

Environmental, Social and Governance (“ESG”) investments in a portfolio may experience performance that is lower or higher than a portfolio not employing such practices. Portfolios with ESG restrictions and strategies as well as ESG investments may not be able to take advantage of the same opportunities or market trends as portfolios where ESG criteria is not applied. There are inconsistent ESG definitions and criteria within the industry, as well as multiple ESG ratings providers that provide ESG ratings of the same subject companies and/or securities that vary among the providers. Certain issuers of investments may have differing and inconsistent views concerning ESG criteria where the ESG claims made in offering documents or other literature may overstate ESG impact. ESG designations are as of the date of this material, and no assurance is provided that the underlying assets have maintained or will maintain and such designation or any stated ESG compliance. As a result, it is difficult to compare ESG investment products or to evaluate an ESG investment product in comparison to one that does not focus on ESG. Investors should also independently consider whether the ESG investment product meets their own ESG objectives or criteria. There is no assurance that an ESG investing strategy or techniques employed will be successful. Past performance is not a guarantee or a dependable measure of future results.

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The indices selected by Morgan Stanley Wealth Management to measure performance are representative of broad asset classes.  Morgan Stanley Wealth Management retains the right to change representative indices at any time.

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