As high inflation makes the Fed more hawkish and recession fears rise, many advisors are focusing on the S&P 500 with characteristic large-cap tunnel vision.

Amid all this, there’s been little notice of a market dislocation that has developed over the past 12 or 13 months: Despite much stronger earnings, S&P small caps have underperformed large caps by nearly 13% (2.1% to 14.9%).

For advisors convinced that a recession will begin this year or early next, a lack of attention to this dislocation might be a strategic misstep.

Though many assessments of the economy, pointing to current brisk growth, don’t suggest a recession before 2024 (if even then), many advisors persist in drinking the recession-is-near Kool-Aid. They obsess over the two-year/10-year Treasury curve as if it were a Delphic oracle, but this is the wrong curve. The more predictive one is the three-month/10 year, which is currently steepening. And regardless, recession forecasting should involve other factors.

Yet, especially for those with recessionoia, this would be a natural time to focus on small caps.

Strong Exit
That’s because small caps are generally more resilient against recession than large. One reason for this is that they often enter recessions already beaten up. And relative to large caps, they’re beaten up now. The Russell 2000 was down 23% from its 2021 peak through April, while the S&P 500 was down about 13%.

Small cap performance when exiting recessions is another matter. They’ve bested large caps coming out of nine of the last 10 recessions, with outperformance beginning roughly at the midpoint and continuing for about a year after recessions end. 

Also, small caps have historically outperformed large over some extremely long periods and, notably, it’s been years since they’ve done so. From February of 2000 through mid-April, IWM was up 313% compared to SPY’s 205%. However over the last five years, large caps have outperformed small two to one. This history, along with the current dislocation, might be the basis for a strategy to buy small caps now, regardless of where you stand in the recession fear spectrum.

Generally, it’s hard for long-term investors to go wrong by buying well-chosen, beaten-up stocks with low-risk characteristics. And the equity risk premium for small cap value stocks is currently double that of large caps. As of early March, Vanguard’s S&P 500 fund had an earnings yield of 5.07%. Measured against a 10-year Treasury rate of 2.72%, this makes the fund’s equity risk premium 235 BPS. At the same time, the equity risk premium of Vanguard’s small cap value fund was 570 BPS—from applying the same math to its much lower P/E, 11.9. Five hundred BPS, of course, reflects miniscule historical risk.

Good Opportunities
Some good current opportunities in small cap stocks lie in a range of sectors. The most attractive of these stocks have a P/E less than or equal to their earnings growth (that is, a PEG Ratio of 1.0 or less), have posted an upside surprise in their last earnings announcement, and pay a dividend.

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