So far, market action in 2024 has largely resembled that of last year. A relative handful of mega-cap tech stocks have powered returns of the S&P 500® Index, led in particular by companies at the forefront of advances in artificial intelligence.
While precise market timing is always hard to predict, many strategists believe this narrow market leadership will eventually broaden, and that a wider range and number of stocks may start to participate in market gains. Small-cap stocks are one asset class that may be due for some catch-up.
In recent weeks, there’s already been some evidence of a broadening as the S&P 500 Equal Weight Index (which gives a greater weighting to smaller companies and less weighting to the largest companies, relative to its better-known cap-weighted counterpart) finally struck new all-time highs for the first time in more than 2 years.
A skewed risk-reward tradeoff
Small caps could still have miles to go to catch up to the pack. While major large-cap indexes such as the S&P, Nasdaq, and the Dow Jones have set record high after record high this year, as of mid-March the Russell 2000 Index of small companies was still about 18% below its all-time peak, which it set in November 2021.
Of course, the upside of sluggish performance is often more attractive valuations. “The valuation gap between small caps and large caps has been extreme,” says Denise Chisholm, Fidelity’s director of quantitative market strategy. Based on yardsticks such as price-to-book value, Chisholm calculates that, relative to large caps, small caps were recently in the bottom decile of their historical valuation range since 1990.
Moreover, valuation spreads among the Russell 2000 stocks are unusually wide (measured by the gap between the most- and least-expensive quartiles). “That’s an expression of fear,” says Chisholm, and indicates that small-cap stocks are priced in anticipation of a recession, and could have plenty of room for recovery in a soft-landing scenario. In the past, when valuation spreads have been this wide, the Russell 2000 has produced average returns of almost 40% over the following 12 months, according to Chisholm’s research.1
“In my opinion, your risk-reward tradeoff is very skewed in favor of small caps,” she says.
A potentially constructive setup from earnings and interest rates
To be sure, low valuations can become a trap if earnings erode. But analysts are expecting the opposite. After declining in 2023 on interest-rate pressures and bank-sector volatility (financials have a much larger weighting than for large-cap indexes), analysts expect earnings for small caps to jump 12% in 2024, compared to 9% for large caps.2
Any eventual cut in interest rates—which the Fed has indicated is likely to be on the table at some point this year—might only stack the odds further in small caps’ favor. “Small caps have historically benefited more than large caps from the first rate cut of a cycle,” says Chisholm, based on her research into market history. “And their advantage has been even greater when earnings also improved.” Historically, she says, small caps have beaten large caps more than 75% of the time in periods with similar market dynamics.3
Fidelity managers on the ground have been observing the same dynamic. “High-quality small caps with good products are very attractive in my opinion,” says Shadman Riaz, lead manager of Fidelity® Stock Selector Small Cap Fund (
One other factor potentially working in small caps’ favor has been the rebound of merger and acquisition activity that started in the fourth quarter of 2023. This is particularly important for valuations of smaller companies, since these are the ones that big companies tend to acquire or that investors seek to buy to take private.
“M&A has really picked up since the Fed indicated it may be done raising rates,” says Gabriela Kelleher, manager of Fidelity® Small Cap Value Fund (
Fund top holdings4
Top-10 holdings of the Fidelity® Small Cap Value Fund (
- 2.6% – Brookfield Infrastructure (
) - 2.4% – Eastern Bankshares Inc. (
) - 2.2% – US Foods Holding Corp. (
) - 2.2% – Brunswick Corp. (
) - 2.1% – Lumentum Holdings Inc. (
) - 2.1% – Insight Enterprises Inc. (
) - 2.0% – Jones Lang LaSalle Inc. (
) - 1.9% – Cadence Bank (
) - 1.9% – First American Financial Corp. (
) - 1.9% – Concentrix Corp. (
)
(See the most recent fund information.)
Investing in the American consumer
There’s an old saying in investing that you should “never bet against the American consumer.” Indeed, the surprising strength and resilience of US consumer spending has been widely credited with helping to keep recession at bay in the past year. Both Kelleher and Riaz have found compelling opportunities recently in the consumer discretionary sector, which encompasses companies that cater to “wants” rather than “needs” of consumers (and which was one of the top-performing sectors last year).
Brunswick (
Brunswick and BRP are both venerable companies; SharkNinja (
Fund top holdings4
Top-10 holdings of the Fidelity® Stock Selector Small Cap Fund (
- 1.5% – Academy Sports & Outdoors Inc. (
) - 1.5% – Fabrinet (
) - 1.3% – Simpson Manufacturing Co. (
) - 1.3% – SPX Technologies Inc. (
) - 1.3% – Insight Enterprises Inc. (
) - 1.2% – Federal Signal Corp. (
) - 1.2% – Synovus Financial Corp. (
) - 1.1% – Advanced Energy Industries Inc. (
) - 1.1% – Commercial Metals Co. (
) - 1.1% – Rush Enterprises Inc. (
)
(See the most recent fund information.)
Industrial, tech, and energy needs
Riaz has also been looking for potential beneficiaries of the big-picture shifts happening in the US economy. He’s been finding them in the industrials sector, which is the largest sector weighting in the small-cap universe, as well as in the tech sector.
“Trends that could benefit industrials include onshoring, fluid global supply chains, infrastructure spending, cloud computing, data center buildouts, as well as new manufacturing facilities that are increasingly being built in the Southeast of the US,” he says.
Two potential beneficiaries he’s identified are Diodes (
Riaz also feels that securing a reliable supply of energy—including both fossil fuels and renewable energy—may be an enduring theme that could continue to drive investment results for years to come. “I believe that we’re in a world that is fundamentally short of energy, and the transition to clean energy will be more expensive and take longer than people realize,” he says. Since it’s gotten harder to squeeze additional oil out of resources such as US and Canadian shale formations, oil equipment and services that can boost shale productivity have been in demand.
Two examples of this theme have been Liberty Energy (
Nextracker (
Finding investing ideas
Fidelity offers a variety of mutual funds and ETFs that focus on small-cap companies, including the following:
Fidelity small-cap mutual funds:
- Fidelity® Small Cap Discovery Fund (
) - Fidelity® Small Cap Growth Fund (
) - Fidelity® Small Cap Stock Fund (
) - Fidelity® Small Cap Value Fund (
) - Fidelity® Stock Selector Small Cap Fund (
)
Fidelity small-cap ETFs:
- Fidelity® Enhanced Small Cap ETF (
) - Fidelity® Fundamental Small-Mid Cap ETF (
) - Fidelity® Small-Mid Multifactor ETF (
)
Investors can search for fund investing ideas from Fidelity and other fund providers with Fidelity’s Mutual Fund Evaluator or ETF/ETP screener. Those interested in individual stocks can research small-cap investment ideas with Fidelity's Stock Screener.