It’s been a tumultuous year for small-cap equities and the relevant exchange traded funds. But there could be reasons to believe smaller stocks have rebound potential.
That could support the upside for ETFs such as the Invesco NASDAQ Future Gen 200 ETF (QQQS). For much of this year, QQQS and its small-cap ETF brethren have been confounded by recession speculation and conjecture regarding what the Federal Reserve’s next moves will be when it comes to monetary policy.
Recession expectations have been dramatically dialed back in recent months. But valuations on small-caps arguably imply calamity on par with deep recession conditions. Likewise, while Treasury yields are elevated, it appears the Fed is unlikely to hike rates again anytime soon. Add it all up, and recent weakness among small-cap ETFs may be overdone.
QQQS Drivers
Understanding the primary determinants of small-caps’ success isn’t difficult. And in what could be good news for QQQS, the stars are aligning on one of the two fronts.
“Domestic growth and valuations are the two largest drivers of small-cap equity performance, explaining roughly two-thirds of Russell 2000 Index returns in our estimate. In an environment of resilient U.S. growth, we turn our attention to valuations, which currently screen cheap relative to expensive large-cap counterparts,” noted Goldman Sachs Asset Management (GSAM).
Over 36% of QQQS’s 200 holdings are classified as value stocks. And a fair amount of the ETF’s components are profitable companies – always an important point. But even more so at a time when profitable small-caps are trading at rock-bottom valuations.
“Profitable companies in the Russell 2000 Index, making up roughly two-thirds of the index, currently trade at a –33% discount to the S&P 500, relative to the long-term average premium of 2%,” added GSAM. “In our view, improving U.S. growth sentiment, alongside historically low relative valuations of cash flow-positive companies, make small-cap equities an attractive alternative to large-cap peers trading at already full valuations.”
Another reason to consider QQQS is that small-cap indexes aren’t as concentrated as, say, the S&P 500. For its part, QQQS allocates just 0.96% of its weight to its largest holding. Add to that, small-cap stocks often outperform following periods of elevated concentration in large-cap indexes.
“Small-cap equities are less vulnerable to a top-heavy market, helping reduce the index’s sensitivity to individual company performance. The Russell 2000 Index outperformed the S&P 500 by 727 bps and 509 bps, annually, in the three years following past periods of peak concentration in the S&P 500,” concluded GSAM.
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