At the beginning of the year, there was widespread belief among economists that inflation and increasing interest rates would likely lead to a recession, which cast a long shadow over Wall Street. Despite this prevailing bearish sentiment, Tom Lee, co-founder of Fundstrat Global Advisors and former chief equity strategist at JPMorgan, maintained an optimistic outlook. Lee predicted that the S&P 500 would jump by nearly 25% to reach between 4,750 and 4,800 by the end of the year, Fortune reported.
Lee’s optimism put him in the minority, as most forecasters surveyed by Bloomberg had a median year-end target of around 4,000 for the S&P 500. Nevertheless, Lee’s belief was grounded in the expectation that the Federal Reserve’s interest rate hikes would effectively control inflation without triggering a recession.
As it turns out, Lee’s predictions now appear spot-on. Inflation has gradually receded from its four-decade high, and the economy is experiencing growth. The S&P 500 has surged by more than 23% year-to-date, coming within a few percentage points of Lee’s January year-end target.
However, some investors are beginning to question whether there are any further gains to be realized. David Donabedian, Chief Investment Officer of CIBC Private Wealth US, has expressed concerns about valuations and the potential for an overly optimistic scenario, cautioning that the recent market rally may be pricing in an unrealistically smooth economic landing without the risk of a recession.
In contrast, Lee, known for his bullish stance, remains upbeat and recommends that investors turn their attention to smaller companies for potential outperformance in 2024. Lee envisions the possibility of small-cap stocks increasing by 50% in the next 12 months, with the Russell 2000 index of small-caps potentially rising from 1,996 to 3,000 by year-end.
How small-cap stocks could soar in 2024
Lee’s rationale centers on the expectation that the New Year will bring relief from inflation pressures and lower interest rates, particularly benefiting small-cap stocks that have been adversely affected by rising borrowing costs. Small-cap companies tend to have higher leverage, making them more vulnerable to the interest rate hikes imposed by the Fed over the past 18 months.
While the Russell 2000 has seen a 14% increase this year, compared to the S&P 500’s approximately 23% gain, Lee believes that continued easing of inflation in 2024, along with expected interest rate cuts by the Fed, could greatly benefit small-cap stocks. Lee is confident that inflation has already been brought under control.
He points to declining consumer inflation expectations, a reliable predictor of actual inflation, as evidence. He also highlights that a significant portion of core inflation, excluding volatile food and energy prices, is attributed to housing, cars, and car services, categories that are no longer experiencing substantial price increases.
Lee’s belief is that if housing inflation stabilizes at 6% and car prices continue to decline, overall inflation will align with the Fed’s 2% target and remain at that level in 2024.
How this might shake out
From an investment perspective, this implies that small-cap stocks, which stand to benefit most from lower interest rates, offer an attractive opportunity, especially considering their favorable pricing relative to larger peers. Lee underscores that small-cap stocks are currently trading at valuations similar to those in 1999 concerning the S&P, marking the beginning of a 12-year period of outperformance.
Comparatively, small-cap stocks are trading below their historical valuations, displaying lower price-to-book and price/earnings ratios than large-cap stocks. In 2023, small caps are not only trading at a substantial discount compared to large caps but also below their historical valuation averages.
Maintaining a balanced perspective
It’s still important for investors to maintain a balanced perspective when evaluating the sector. A low valuation does not necessarily mean “cheap” or “inexpensive.” While small-cap stocks are presently trading at reduced valuations, this doesn’t guarantee an imminent rebound. However, when considering the broader economic outlook, there are reasons for optimism regarding the future prospects of small-cap stocks.
Throughout 2023, small caps faced more challenges than their large-cap counterparts, primarily due to higher interest rates and the looming threat of a recession. In deteriorating economic conditions, lenders were less inclined to extend loans to smaller companies, exacerbating their struggles. Consequently, small-cap stocks lagged behind large caps in terms of returns.
Now, with the worst potentially behind us, small-cap stocks may be on the verge of a resurgence. The Federal Reserve’s apparent halt in raising interest rates and the diminishing risk of a recession in the coming year should contribute to an improved lending environment. Overall, the outlook for small-cap companies in 2024 appears promising.
