Optimism Abounds for Small-Caps

Small-caps and related ETFs have laggard large-cap counterparts in 2023, but there could be a silver lining to that scenario. Some of market observers’ optimism when it comes to smaller stocks is attributable to at least two factors.

First, the asset class arguably already priced in a harsh recession, a scenario economists believe will not come to pass. Second, recent struggles by small-caps have made the group unusually inexpensive. Perhaps too cheap to ignore, according to some investors.

Those factors and others could signal rebound potential with ETFs such as the Invesco NASDAQ Future Gen 200 ETF (QQQS). Over the past several months, the small-cap Russell 2000 Index, which is not QQQS’ underlying index, has lagged the large-cap S&P 500. In a vacuum, that sounds ominous for the Invesco ETF, but there’s more to the story.

QQQS Silver Linings

As noted above, small-caps have struggled in recent months, but the good news for investors considering an ETF such as QQQS is that the cost of admission (valuation) is likely lower than expected.

“Since the end of July, the Russell 2000’s price-to-book has fallen by 16% to 1.8, which is close to the biggest discount to large caps on record. When small caps have traded at this type of discount in the past, they have historically gone on to deliver strong returns over the following 12 months and tended to outperform large caps,” according to BNP Paribas research.

Another point in favor of QQQS is that many of the fund’s holdings are profitable and have solid balance sheets — two traits that could provide a buffer should the economy contract. Then again, economic data could be signaling that a soft landing is attainable. That too would be a boon for QQQS.

“The job market is robust and balance sheets among our US small-cap companies remain healthy. We see valuations as compelling and we expect the asset class to perform well once it becomes clearer that the US economy is not heading into a deep recession. In my view, we are at – or close to – a favourable entry point for US small caps,” added BNP Paribas.

Adding to the allure of QQQS is the fact that the valuation gap between small-caps and large-caps is at a two-decade high. That scenario won’t be permanent, and as the gap narrows, ETFs such as QQQS stand to benefit, particularly if economic data cooperates.

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