Small-cap stocks have lagged behind large caps in the past few years. For instance, the Russell 2000 has underperformed the SPX Index by 35% since 2021. Additionally, the Russell 2000/SP500 ratio has dropped to 0.5, a level not seen since 2002.

Mean reversion

Is there a possibility of mean reversion from here? It’s uncertain. Small-cap companies are predicted to recover earnings later in the year, likely in H2. Considering technical mean reversion levels, a small allocation to small caps could be considered.

We’re cautious about small caps at the moment. While we anticipate a potential rebound, it might not happen until the second half of 2024, offering positive surprises. Given the lofty valuations of some large caps, especially in tech, and the higher second derivative valuation with large caps, we’re hesitant to heavily add to small caps in a diversified portfolio. This valuation concern extends to EU small caps as well.

Sector selection is important

If you’re inclined to include small and mid-cap equities, we suggest focusing on trending sectors like Tech, Healthcare, and Financials as favorable buys. However, we advise against Auto and Real Estate at present, as the momentum for these sectors is not yet confirmed.

In conclusion, we anticipate small caps to be in a better technical position in a few months, making them more attractive. While caution is advised, maintaining a small allocation in the mentioned sectors with small-cap equities is recommended.