Welcome to RBC’s Markets in Motion podcast, recorded December 7th, 2023. I’m Lori Calvasina, head of US equity strategy at RBC Capital Markets. Please listen to the end of this podcast for important disclaimers. Three big things you need to know: First, similar to the S&P 500, R2000 returns tend to be positive but modest in Presidential election years. Second, the valuation appeal of Small Caps runs deep and exists within both Growth and Value using both equal weighted and market cap weighted P/E’s. But Small Caps’ valuation appeal has only recently emerged on equal weighted P/E’s, helping explain why Small Caps have had a difficult 2023. Third, investor sentiment is on the cusp of looking overly enthusiastic again on the weekly AAII survey, restraining our enthusiasm for the US equity market in the near-term.
If you’d like to hear more, there’s another five minutes.
- The outlook for Small Caps has been of interest to many of the investors we’ve spoken with over the past month, even those who are not dedicated to the space. The topic tends to come up in the discussion of a possible leadership rotation out of mega cap Growth’s Magnificent 7 and whether the stock market is finally ready for new leadership and greater breadth.
- As discussed in our 2024 equity market outlook report, we are in the camp that Small Caps look intriguing, that the Growth trade is due for a pause (though perhaps only a short-term one), and believe that it makes sense to add to Small Caps.
- Our work on how Small Cap performance is tracking the recovery in consumer confidence off 2022’s recession-type low, how Small Cap balance sheets are not as bad as feared, and how Small Cap fund flows have improved since October has generally been well received.
- One follow-up question we’ve been getting from Small Cap PMs specifically is how Small Caps perform in Presidential election years. We highlight the answer in a new chart this week, which shows that, similar to the S&P 500, the R2000 tends to post gains in Presidential election years, just more modest gains than non-election years.
- Interestingly, the average Presidential election return tends to be a bit stronger in Small Cap than Large Cap. Since 1979, Small Caps tend to rally 9.8% while the S&P 500 has posted an average gain of 5.8%.
- One of the go-to charts in our deck on Small Caps highlights how deeply attractive they are relative to Large Caps on a market cap weighted P/E multiple.
- Another follow-up question that we were getting last week was whether Small Caps look cheap relative to Large Cap within both Growth and Value, or if it’s just a gap being driven by highly expensive valuations in mega cap Growth names.
- We took a trip down the data rabbit hole and looked at Small/Large relative P/E’s broadly, as well as within the Growth and Value segments separately, on both equal weighted P/E’s and market cap weighted P/E’s.
- We found that Small Caps look deeply attractive relative to Large Caps today on the market cap weighted stats, both broadly and within Growth and Value.
- Small Caps also look attractive relative to Large Caps within both Growth and Value using equal weighted P/Es.
- But we also found that on the equal weighted stats, Small Caps did not look compelling relative to Large Caps back in 2Q23. Relative valuations were closer to the long-term average back then.
- This helps explain to us why Small Caps have had such a tough year in 2023, and how the set up has changed for them in a more favorable way heading into 2024.
- Last week, net bulls in the weekly AAII survey rose to 20.5% on the four-week average, just shy of 1 standard deviation above the long-term average. From that range, between the average and plus one standard deviation mark, the S&P 500 tends to see solid 12-month forward gains of 8.5% and slightly positive 3-month forward returns of 1.6%.
- From the range this indicator seems likely to enter soon - between plus one and plus two standard deviations above the long-term average on the four-week average - the S&P 500 still tends to experience a decent 12-month forward return of 6.5%, but a nearly flat average 3-month forward return of just 0.7%.
- This suggests to us that the case for a short-term pause in the recent stock market rally has grown, but does not alter our constructive 12-month view of our S&P 500 target for 2024 of 5,000.
That’s all for now. Thanks for listening. And be sure to reach out to your RBC representative with any questions.