Why U.S. small and midcaps are further along on the road to recovery

Stocks in major markets have started the year on a positive note on declining inflation rates and the belief that major central banks are close to the end of their rate hike cycles. Also contributing has been better-than-feared economic data.

In the U.S., small and midcap indexes have outperformed large capitalization indexes. The S&P SmallCap 600 and the S&P MidCap 400 have rallied 5.0 percent and 4.6 percent, respectively, year to date through January 18. At the same time, the large-cap S&P 500 Index is up 2.3 percent.

We think small and midcaps have the potential to outperform large caps this year, and should represent Overweight positions within U.S. equity allocations. RBC Capital Markets, LLC’s Head of U.S. Equity Strategy Lori Calvasina also recommends small caps for 2023, and this segment of the market is her highest conviction call.

Following are six characteristics that make small and midcaps attractive, in our view.

Below-average absolute valuations: The S&P SmallCap 600 forward price-to-earnings (P/E) ratio is 14.1x, well below the 10- and 20-year averages of 20.8x and 19.6x, respectively, according to Bloomberg data. This index also trades at a discount to its historical price-to-free cash flow average. The S&P MidCap 400 appears undervalued as well, trading at 14.4x compared to the 10- and 20-year averages of 19.0x and 18.1x, respectively. In contrast, the S&P 500 is trading at 17.5x, above its 20-year average of 16.8x.

Inexpensive relative valuations: When the valuations are pitted directly against the S&P 500 in a head-to-head matchup, the small and midcap P/Es are near their lowest points since the Tech bubble based on consensus forward earnings estimates. In fact, they are deeply below average on a relative basis, as the charts on page 2 illustrate. This is a key reason why we recommend sizing down capitalizations. Historically, such valuation disparities have coincided with small and midcap outperformance.

Small-cap and midcap index valuations are near their lowest levels in 20 years compared to large caps

Ratio of S&P SmallCap 600 to S&P 500 price-to-earnings (SML/SPX P/Es)

The line chart shows the ratio of S&P SmallCap 600 to S&P 500 price-to-earnings (SmallCap divided by S&P 500) since January 2003. The average during that period is 1.18. From 2003-2009, small cap valuations were mainly below average. From 2009-2016, small cap valuations were mainly above average. From 2018 onward, small cap valuations have been mainly below average with the exception of a strong spike during the COVID-19 crisis in 2020. Since mid-2021, small cap valuations have been well below average, and are currently near the lowest level in 20 years at 0.82.

Ratio of S&P MidCap 400 to S&P 500 price-to-earnings (MID/SPX P/Es)

The line chart shows the ratio of S&P MidCap 400 to S&P 500 price-to-earnings (MidCap divided by S&P 500) since January 2003. The average during that period is 1.09. From 2003-2005, midcap valuations were mainly below average. From 2005-2009, midcap valuations were both below and above average at times. From 2009-2017, midcap valuations were mostly above average. From 2018 onward, midcap valuations have been mainly below average. Since mid-2021, midcap valuations have been well below average, and are currently near the lowest level in 20 years at 0.82.

Source - RBC Wealth Management, Bloomberg; Month-end data except for final data point on 1/18/23

Better earnings profile: Consensus earnings growth estimates for all major indexes are still trending down and this pattern will probably persist for at least another quarter—the magnitudes of retrenchment will depend on overall economic momentum. This is normal when GDP growth is vulnerable and the economy is sluggish or slowing.

While all capitalization sizes are well along in the downward earnings estimate revision process, we think the prices of small and midcap indexes have factored in any further cuts to earnings estimates more so than the S&P 500.

Additionally, since June 2022, earnings revision trends for the small-cap Russell 2000 Index have been more favorable than trends for the S&P 500. Earnings growth for small-cap indexes should have the potential to exceed that of the S&P 500 in 2023.

Already factoring in recession: Calvasina believes small caps appear to be baking in a recession. Based on her analysis of the relationship between economic trends and equity indexes, she thinks small caps have been factoring in a retrenchment in manufacturing since last summer (this retrenchment began in November), and for quite some time they have been discounting a spike in jobless claims normally associated with a recession (such a spike has yet to materialize).

Stronger liftoffs when new bull market cycles begin: It is not yet clear whether the index price troughs reached in 2022 were the lowest levels of this bear market cycle. We think this will largely depend on economic trends (will there be a hard or soft landing?) and monetary policy (will the Fed overtighten?). These uncertainties should become clearer in the months ahead.

Regardless, when the U.S. economy works through challenging periods, small and midcaps often lead the early stages of the next bull market phase. For example, small caps have historically underperformed during the early part of recessions, and then started to outperform at roughly the midway point. Calvasina points out this has often coincided with an upward move in the unemployment rate, which typically occurs when it is well understood that recessionary forces have taken root.

Diversification benefits: Having exposure to small and midcaps obviously provides diversification in terms of market capitalization. But there are two other important diversification benefits:

• Small and midcap indexes are less dominated by a small number of stocks. The 10 largest stocks in the S&P 500 represent a whopping 24.4 percent of that index, whereas the 10 largest stocks in the S&P SmallCap 600 and S&P MidCap 400 represent only 5.7 percent and 6.1 percent of those indexes, respectively.
• The sector weightings differ meaningfully between capitalization sizes. Information Technology has a much higher weighting in the S&P 500, whereas Industrials, Financials, and Consumer Discretionary have higher weightings in the midcap and small-cap indexes, as the table illustrates.

We think these six characteristics provide reasons to Overweight U.S. small and midcaps within U.S. equity allocations in 2023, as they make it more likely these areas of the market will outperform.

Sector weightings and other characteristics differ meaningfully by market capitalization

Source - S&P Dow Jones Indexes; data as of 12/31/22