Small-Cap Opportunity Set Still Looks Attractive | ETF Trends

Small-caps lagged last year. That’s because a small number of mega-cap growth stocks accounted for the bulk of the broader market’s returns. But there’s evidence the upside being generated in 2024 has more breadth than what was seen in 2023. That includes some signs of participation from small-cap stocks.

For example, the Russell 2000 Index is high by 2.76% over the past month, and 4.45% year-to-date. Those gains could signal opportunity with ETFs such as the Invesco NASDAQ Future Gen 200 ETF (QQQS).

As have many small-cap ETFs, QQQS entered 2024 with many of its holdings trading at steep discounts relative to large-cap equities. Even with recent strength among smaller stocks, the asset class remains attractive on valuation.

“Valuations are compelling versus large caps, particularly on a price-to-earnings basis. The small-cap Russell 2000 index is trading at 65% of the large-cap Russell 1000 index, compared to a long-term average of just under 100%, so we are seeing a material relative undervaluation,” noted Jeff Dailey, head of U.S. equities at BNP Paribas.

Catalysts Abound for QQQS

All valuation gaps between large- and small-cap benchmarks don’t need to be closed for the latter to rally. That’s because there are other potential tailwinds. Those include the possibility that the Federal Reserve will soon lower interest rates.

“Easing cycles typically benefit small caps, and hiking cycles typically hurt [financial]markets; [markets are]currently calling for between two and four rate cuts this year. Macroeconomic data could push back the timing or [the number of]Fed cuts. Our base case is that we’re much closer to a Fed cut than a hike, and that’s good for small caps,” added Dailey.

Specific to QQQS, another potential tailwind is a sustained rebound by biotech stocks. Healthcare equities, many of which are biotech, represent more than 53% of the QQQS portfolio. And 14.1% of those names are members of the S&P Biotechnology Select Industry Index.

Though the sentiment is relevant to QQQS’ healthcare exposure, there are expectations that mergers and acquisitions could increase as 2024 progresses. And small-cap companies — healthcare and otherwise — make for prime takeover targets.

“There are [signs pointing to]a more vibrant mergers & acquisitions environment. M&A has been particularly soft over the last couple of years due to tighter financial conditions and economic uncertainty. There is now a high probability that that will reverse, particularly with a healthy pipeline of deals that CEOs have lined up for strategic reasons. And M&As are always a nice tailwind for small caps,” concluded Dailey.

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