As always, opportunistic, long-term investors should be assessing the positioning of their equity portfolio based on forward-looking expectations. For US equity investors, we believe the outlook increasingly favors smaller caps and quality.

How did we get here?

It’s been an abysmal market environment thus far in 2022. Equity levels tumbled in January sparked by a new hawkish tone by the US Federal Reserve (Fed) regarding the path of monetary policy, and things haven’t really gone well for share prices since.

A strong second-quarter corporate earnings season, coupled with tentative signs of easing inflation, prompted a robust rally across US equity markets in July. This rally didn’t have legs, however. The economic outlook weakened from there alongside a persistently hawkish Fed determined to fight inflation. This prompted a strong pullback in equity levels to finish the third quarter.

It capped the worst first nine months of a calendar year in decades, with large-caps down almost 25% and small-caps down 25.1%.¹ Since their recent high last November, small caps have sunk 31%.²

These significant, negative market moves are perhaps unsurprising, given expectations of slowing economic growth and the increasing probability of a recession on the horizon. Moreover, underperformance of small caps relative to large caps is consistent with past periods of weakening growth expectations, taking account of the higher risk often associated with smaller companies.

Where do we go from here?

The meaningful drop in US stocks this year points to market expectations of slowing economic growth, if not recession. The big question for equity investors is whether this pricing is more punishing than it needs to be, or if more pain lies ahead.

While equities may very well continue lower from here, history demonstrates that equity markets tend to begin their recovery prior to GDP bottoming out – i.e. before a recession has ended.

Chart 1 illustrates the average performance of US stocks in the months prior to and after the start of the last six US recessions. On average, these recessions lasted 11 months, with equity markets bottoming out and starting to recover just three months into a recession. Historically, small caps lagged large caps during the equity declines into the early part of these recessions, but outpace them during the recovery periods. In fact, on average, small caps outperformed large caps by 8% over the first six months of the recovery and 14% over the first 12 months.

Source: abrdn, FactSet, October 2022. Large caps represented by Russell 1000 Index, small caps represented by Russell 2000 Index. Past recessions: Jan – Jul 1980, Jul 1981 – Nov 1982, Jul 1990 – Mar 1991, Mar – Nov 2001, Dec 2007 – Jun 2009, Feb – Apr 2020.

Valuations support small caps…

The strong share price performance of big US tech and e-commerce companies helped large-cap stocks outperform small-cap stocks in recent years. Healthy returns in these sectors also contributed to the relatively high valuation of the US large-cap equity market.

The valuation discount of small caps relative to large caps today is as large as it has been in more than 40 years (chart 2). Notably, after small caps reached a similar level of “cheapness” in early 2001, small-cap stocks materially outperformed larger caps over the subsequent three-, five- and 10-year periods.

Source: FactSet, Bloomberg, abrdn, September 30, 2022. Note: Excluding negative earnings. For illustrative purposes only. Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially.

Valuations are not especially instructive for near-term performance outlooks, but are informative when considering longer time-horizons. Chart 3 plots the forward five-year annualized small-cap returns relative to large caps at different historical relative valuation levels.

In the past, when small-cap valuations were at a similar discount to today — residing among dots to the furthest left — small caps materially outperformed large caps over the subsequent five-year periods.

Source: FactSet, Bloomberg, abrdn, December 31, 1978 – September 30, 2022. Note: Excluding negative earnings. For illustrative purposes only. Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially.

…and so do economic dynamics

Valuations aside, economic dynamics also appear primed to support small caps caps over the next several years. The US looks to be in the early stages of a strong corporate capital expenditure (capex) cycle – and smaller companies’ top-line growth tends to be more correlated to capex growth than that of larger companies.

Companies have been sitting on high levels of cash in recent years, and we expect businesses to put this cash to work. Major infrastructure investment has the potential to accelerate capital spending, for example.

We also expect heightened geopolitical risks to spark capital reshoring in coming years. We suspect US firms will raise onshore investment in areas such as manufacturing and supply chains – highlighting the potential for increased capital spending.

We believe these trends could boost certain recipient sectors such as industrials, materials, energy and utilities – which are better represented among small caps than large caps.

Quality poised for a rebound?

High-quality equity market segments, such as companies with strong profitability, low leverage and greater earnings consistency, have underperformed so far this year. However, given the prospects of economic recession, we believe investors would do well to focus on quality. Companies that have strong business models – with pricing power, healthy balance sheets and unique growth drivers – will be better placed in an environment of slow growth, high inflation and rising interest rates.

Chart 4 shows the average performance of various US equity styles in the months prior to and after the start of the three US recessions this century. On average, quality performed quite well – outperforming the other styles during the recessionary period and beyond.

Source: abrdn, FactSet, MSCI, October 2022. Style performance reflects the performance of the MSCI USA Quality Index, the MSCI USA Minimum Volatility Index, the MSCI Momentum Index and the MSCI Value Weighted Index relative to the MSCI USA Index. Recession periods: Mar – Nov 2001, Dec 2007 – Jun 2009, Feb – Apr 2020.

Focusing on the future: Quality and small caps

Predicting the market’s bottom and start of a recovery is a fool’s errand. Nonetheless, the depth of the stock market decline this year at least suggests we’re closer to the bottom than at the start of this year.

If history is a guide, stock markets could start to recover before the green shoots of an economic rebound appear. To prepare for this, we believe investors would be wise to ensure appropriate exposure to small caps in their portfolio. Not only do small caps tend to lead large caps during market rebounds, but they also offer compelling valuations today.

Despite a difficult year, we urge investors not to be discouraged by the underperformance of quality. Looking ahead, a focus on quality has the potential to strengthen returns during recessionary periods.

IMPORTANT INFORMATION

Equity stocks of small and mid-cap companies carry greater risk, and more volatility than equity stocks of larger, more established companies. Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially.

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