Don't Swing to Small Stocks for the Wrong Reasons

Some investors anticipate that the new administration’s policies will favor small-cap stocks. Mitch offers a word of caution.

Don’t Jump into Small-Cap Stocks for the Wrong Reasons Post-election “animal spirits” continue, with risk assets persisting in rally mode. As I wrote in a recent column, one area of heightened interest for investors has been small-cap stocks. The Russell 2000 Index posted its best single-day gain in almost two years following the election, as investors positioned for accelerating growth (via tax cuts and deregulation) combined with potential policies (tariffs) that favor companies with high relative levels of domestic production and revenue, i.e., small caps.1 Small-cap value has been the biggest beneficiary of these ‘themes’ in the weeks since the election, outperforming mid-cap and large-cap stocks across the value and growth spectrum. The trade is logical on its face—small-cap value stocks derive about 80% of their revenues domestically. The tax cut, deregulation, and tariff themes may play out just as investors are anticipating they will. But the decision to crowd into the small-cap trade—or significantly increase your allocation to small-caps now—would mean making assumptions about what future policy will look like, and how those policies will impact the economy. In other words, the allocation decision would be driven by changes to sentiment, not changes to economic fundamentals. That’s why I caution jumping into small-cap value stocks for the wrong reasons. November Market Outlook: Key Trends to Watch As small-cap stocks surge amid post-election enthusiasm, the real question is: Will these gains hold as policy expectations meet economic reality? Discover our insights in the November Stock Market Outlook Report 2, where we explore U.S. economic trends, global developments, and the forces shaping small-cap performance. This report includes valuable insights into: Capital markets commentary: Should investors strategically position for a Trump presidency? Key U.S. economic data – Numbers and trends Global market data Zacks S&P 500 earnings insights Zacks sector picks And more… If you have $500,000 or more to invest, request our free November Stock Market Outlook Report 2 today! To be sure, history shows that high-quality small-cap stocks have delivered competitive returns relative to the broad stock market over long stretches of time, in many cases outperforming. Small-cap stocks also give investors exposure to companies with strong prospects for long-term earnings growth, while reaping potential benefits of broader portfolio diversification—helping to drive strong, long-term risk-adjusted returns. These would be among the reasons to have an allocation to small-cap stocks, which is very different from political and/or sentiment drivers. History tells us that the short-term, sentiment-driven small-cap trade has not panned out so well. In November and December 2016, after President Trump had won that election, small-cap stocks rallied strongly—for many of the same reasons we're seeing today. The trade then was referred to as the “Trump Bump,” which was based on expectations for tax cuts, deregulation, infrastructure spending, protectionism, and higher growth rates. But by 2017, the trade had fizzled, and small-cap value was the worst-performing size/style category that year. We saw a similar pattern in 2020. After President Biden’s victory, there was rising enthusiasm for the “reopening trade,” and small-cap value stocks delivered a powerful run-up. Since value stocks, in general, underperformed in the pandemic period, it was thought that a surge in economic vitality would revive investor enthusiasm for this attractive valuation category. This trade did well for a couple of years, but then the artificial intelligence effect on mega-cap technology stocks and large growth stole the show. Though President-elect Trump has laid out an economic policy agenda that would arguably benefit small-cap stocks, much remains to be known. For instance, which of the policies will actually get enacted, and to what degree will they be altered or watered down? Will some policy ideas—like infrastructure in 2016—not get passed at all? Time will tell, but I think the overarching takeaway should be the same as it has been in previous election cycles. That is, if you’re going to invest in small-cap stocks, do so because you’re seeking to diversify your portfolio into an asset class with attractive long-term risk/reward profile—not because you think small-caps are poised to dominate in the next year. Bottom Line for Investors As I’ve written many times before, I firmly believe that fundamentals like earnings, cash flows, and valuations will drive markets far more over the long term than politics and policy. After all, elections happen every four years, and business and economic cycles basically never fit neatly into these four-year boxes. That being said, we have a constructive outlook on the earnings picture for U.S. companies, and high-quality small-cap stocks trade at a discount to their large-cap peers—even though many of them have similar profit margins and free cash flows. For long-term growth-oriented portfolios, that makes a good argument for having a small-cap allocation for longer than just the next four years. This perspective highlights the opportunities in small-cap stocks at current valuations, making them worth a closer look. Our November Stock Market Outlook 3 dives deeper into the factors driving the market forward. Inside, you’ll find in-depth analysis and actionable strategies, including: Capital markets commentary: Should investors strategically position for a Trump presidency? Key U.S. economic data – Numbers and trends Global market data Zacks S&P 500 earnings insights Zacks sector picks And more… If you have $500,000 or more to invest, request our free November Stock Market Outlook Report 3 today! About Zacks Investment Management Zacks Investment Management was born out of one of the country’s largest providers of independent research, Zacks Investment Research. Our independent research capabilities from our parent company truly distinguish us from other wealth management firms - our strategies are derived from research and innovation, including the proprietary Zacks Rank stock selection model, earnings surprise and estimate revision factors. At Zacks Investment Management, we work with clients with $500,000 or more to invest, and we use this independent research, 35+ years of investment management experience, and tools we’ve developed to design customized investment portfolios based on each client’s individual needs. 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