2024 US small cap equity perspective

Will the US/major economies be able to avoid a recession? Soft or hard landing?

It seems as if we have been talking about the prospect of a recession since the end of 2021. While we are not in the business of predicting when or if the economy will fall into recession, we do believe the small cap market has already priced in a recession and many companies have been preparing for the possibility of one for some time.

How do you see the rate and inflation path in the US/major economies in 2024?

Using history as our guide we know that small cap returns in the first year of Federal Reserve (Fed) Funds tightening have usually been good. Surprisingly, in the 12 months that followed the first Fed interest rate hike in March 2022, the Russell 2000 was down -11.5% while the S&P 500 was down 7.0%. History shows that 1- and 3-year returns for both indexes were mostly positive following the nine previous initial tightening cycles by the Fed.

At the same time, we know that the subsequent average one-year return for the Russell 2000 Index following the final rate hike is quite strong, averaging 18.4% going back to the mid 1990’s.

What catalyst could drive a significant shift/rebound in your asset class in 2024?

Small-Caps remain mired in a classic bear market, down close to 25% from their peak on November 8, 2021. In addition, it has been well over 500 trading days since the Russell 2000 last closed at a 52-week high, the third longest streak in the Index’s history. The last few months are much of the same, as the Russell 2000 has declined for three straight months through the end of October, down over 16.7%. We see an array of potential triggers that would jump-start small-cap performance, which include the end of the rate hiking cycle, inflation moderating, a labor market that remains strong and consumer spending steady. The strength of capital spending, the reshoring phenomenon, the effects of the CHIPS and Science Act, and AI applications are all highly promising elements whose benefits haven’t yet registered fully, if at all.

Where do you see the best investment opportunities for 2024?

As bottom-up small-cap stock pickers, however, the most significant factor for us is that the majority of the management teams we’ve been speaking to remain cautiously optimistic over the long run. So, while the near-term view is as cloudy as any we’ve seen, there are enough positives for us to have a very constructive view for long-term small-cap returns going forward. Valuations for small-cap stocks are looking more attractive in aggregate. Small caps finished October in a bear market, with the Russell 2000 losing -30% from its last peak on 11/8/21 through the end of the third quarter. Many companies we’ve looked at would appear to have already priced in a recession. Both in terms of price-to-earnings (P/E) and EV/EBIT (enterprise value over earnings before interest and taxes), many small caps look undervalued to us. They look even cheaper compared to large caps. In fact, based on EV/EBIT, small caps remained close to 20-year lows relative to large caps at the end of September. So, the opportunity set in small cap does look compelling to us from a valuation standpoint.

Focus on quality and active management throughout small-caps…given the dramatic change in access to capital, we believe better companies should continue to outperform in these uncertain times.  We remain focused on industrials, financials, and information technology.

What are the main areas of risk in 2024?

The usual list including geopolitics, the US Presidential election, or a crack in the financial system.

What could be a major surprise to markets in 2024? Or what risk factors/opportunities are markets currently not adequately discounting for 2024?

Our confidence is that the asset class itself is poised for recovery. The Russell 2000 Index had an annualized return of just 2.4% for the five-year period ended 9/30/23. This was among the lowest five-year returns since the inception of the Russell 2000 and shows that many small caps have essentially been treading water for the last five years. And while the last five years have been a very trying period for small-cap investors, especially when weighed against the markedly higher returns for large cap over the same five-year span, our long-term confidence is high. We’ve talked before about how these lower-than average annualized five-year returns for the Russell 2000 have historically led to higher-than-average returns over the next five years. The Russell 2000 had positive annualized 5-year returns 100% of the time—in all 81 five-year periods—averaging 14.9%, which was well above its monthly rolling five-year return since inception of 10.4%.