'So bad, it's good': History shows the market's smallest stocks may be poised for a rebound after record underperformance

Business Insider

a day ago

Small-cap stocks were hammered in the aftermath of President Donald Trump's tariffs, but the stage looks set for a rebound this June.
The small-cap track record has been grim recently: the Russell 2000 has seen its worst streak of underperformance relative to the S&P 500 since the dot-com era, and this past May marked the sixth-worst year-to-date performance since 1990.
Small caps, initially perceived as a clear winner of the Trump trade following the election, have emerged as the biggest losers of the trade war. With tariff concerns top-of-mind, investors are viewing small caps as "price takers, not price makers," extra vulnerable to inflation and supply chain disruptions, a note by Evercore ISI senior managing direction, Julian Emanuel, said.
But for the optimists, once you hit rock bottom, the only direction to go is up. In the eyes of Evercore, small caps have become "so bad, they're good."
June outperformance
June has historically been a strong month for small caps, as the FTSE Russell rebalances its indexes and adds or removes stocks based on market cap criteria. This leads to a surge of trading activity that can boost stock prices.
This effect is particularly prominent in the wake of outsized underperformance. In the five other instances of disappointing January to May performance, small caps exhibited strong seasonal reversion during the month of June, outperforming large caps by an average of 4.1%, Evercore said.
The firm believes the market has moved past the point of peak tariff uncertainty, which could further boost the sector's performance in June.
There are other catalysts for a small-cap resurgence as well. Amy Zhang, a portfolio manager at investment management firm Alger, pointed to cheap valuations and the potential for rate cuts.
Small caps have historically traded at a 27% premium relative to large caps due to their higher growth expectations, but on a forward-looking basis, the Russell 2000 is currently only trading at a 11% premium to the S&P 500. This allows investors to get exposure to small caps at a steep discount relative to history, especially as fundamentals and the overall economic environment improve.
Cheap valuations make small caps appealing takeover targets, and a pickup in M&A activity could help lift the group, Zhang told Business Insider. As large companies look to boost growth through acquisitions, smaller firms become prime candidates.
The healthcare sector, the largest component of the Russell 2000, tends to benefit the most from increased dealmaking, according to Bank of America.
Both Emanuel and Zhang believe lower rates, which help smaller companies with higher levels of debt on their balance sheets, could be coming later this year.
"Because it's data dependent, they run the risk of being too late again," Zhang said of the Fed cutting rates. "I think it could be the case, like last year Q4, where the Fed may be in a position again to pivot to 50 basis points of cuts."
Additionally, Zhang sees AI as a long-term tailwind for small caps.
"AI is very deflationary, especially for labor costs," Zhang said. That means companies that adopt AI effectively can expand margins and boost productivity — advantages that could be especially powerful for smaller firms with with smaller budgets.