- Following years of underperformance, LPL thinks now is a good time for investors to consider buying small-cap stocks, according to a note published on Monday.
- While large-cap stocks have proved to be resilient during the COVID-19 pandemic, due to their strong balance sheets and stable earnings, the economy is in a better place today than it was in the spring, which should benefit small-cap stocks, LPL said.
- Here are three reasons why investors should warm up to small-cap stocks, according to LPL.
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The COVID-19 pandemic jolted investors with mounting uncertainty in 2020, which is only being exacerbated by an upcoming presidential election.
That uncertainty has mostly favored large-cap stocks, as their resilient earnings and strong balance sheets provided a level of comfort for investors daunted by the economic uncertainty.
But now, the economy is in a much better place today than it was in the spring, leading LPL to believe that now is a good time to start warming up to small-cap stocks, according to a Monday note from the firm.
Here are three reasons why investors should buy small-cap stocks, according to LPL.
1. "Early cycle environment favors small-caps."
With the Federal Reserve of Atlanta's GDPNow forecast of 35% for gross domestic product growth in the third quarter on an annualized basis, the recession is likely over, according to LPL.
"Given our view that we're in the early stages of the business cycle and a new bull market, we point out that small cap stocks historically have performed well relative to their large cap counterparts coming out of recessions. The story is the same coming off of major bear market lows where, on average, small caps have outperformed large caps by about 15% during the first year of bull markets, according to a study by Ned Davis Research," LPL said.
2. "Streak of underperformance may be over."
"Since the March 23 low, the Russell 2000 has outperformed the S&P 500 Index by more than 13%, and the ratio between the two indexes has moved back above the 200-day moving average for the first time in more than two years. We do not view this as a timing signal to go significantly overweight small caps, but believe it demonstrates that the trend has shifted to a more neutral stance between large and small," LPL said.
3. "Small cap earnings poised for a strong 2021."
"While small cap market returns are typically strong coming off bear market bottoms and out of recessions, strong earnings growth usually follows. Case in point, for 2021 small cap earnings are expected to rebound sharply—potentially by 180% based on the latest FactSet estimates—to more than 10% above 2019 levels. Simply put, greater economic sensitivity provided by small cap stocks compared with large cap stocks may be helpful when economic growth expectations go from bad to less bad, and eventually to good," LPL said.
Still, despite the three reasons that LPL is starting to favor small-cap stocks, the firm acknowledged risks that could derail its bullish investment case. Investors should beware that another economic dip caused by a prolonged COVID-19 pandemic, a weaker US dollar, and higher corporate tax rates would not favor small-cap stocks.