Small-cap stocks outperformed large caps in 2020, but their performance has been lackluster this year.

While the small-cap Russell 2000 index generated an 20% return in 2020 and beat the S&P 500’s 16.3% return, the bulk of the gain occurred during the last months of 2020.

Small-cap performance was outstanding from Sept. 24, 2020 to March 15, 2021 as the S&P 600 — another small-cap index — gained 69%, or more than three times the return of large caps. Since March, small-cap stocks have leveled off, and future returns appear less promising.

“While 2020 was a banner year for small caps, this segment of the market has traded generally sideways for the better half of 2021,” says Mike Loewengart, managing director of investment strategy at E-Trade Financial, an Arlington, Virginia-based brokerage company.

At some point in 2021, investors realized that supply-side constraints and higher inflation “would lead to demand destruction and soften growth expectations,” says Anthony Chan, former chief economist at JPMorgan Chase & Co. Many investors are now penciling in U.S. real gross domestic product growth ranging from 5.25% to 5.5% instead of 6% or more growth.

“Not surprisingly, this has caused the Russell 2000 to underperform the S&P 500,” he says.

If you’re wondering if you should own small caps, here’s what to keep in mind:

— Stock market factors have shifted.

— How small caps perform during inflation.

— Small-cap stocks help diversify over the long term.

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Stock Market Factors Have Shifted

While the U.S. economic recovery is on an upswing, the ongoing pandemic, supply chain bottlenecks and labor shortages continue to affect profit margins. Small-cap stocks tend to be domestic companies, and economic or fiscal challenges facing the U.S. have a greater impact on the balance sheets of these companies compared to larger businesses.

“There have been a number of monkey wrenches that have threatened to disrupt a full recovery,” Loewengart says. “With prospects of slower growth, small caps could potentially see less robust returns, but that doesn’t mean they should be ignored.”

U.S. small caps have historically outperformed when investors expect economic growth to accelerate, and that explains “why the Russell 2000 did so well relative to the S&P 500 in 2020,” Chan says.

With U.S. real GDP growth going from a -3.4% in 2020 to expectations that it would grow by 6% or more in 2021, it was “easy for investors to become enamored with small stocks,” he says.

Small caps tend to be riskier and generate a bumpier ride for investors, Chan says. When U.S. real GDP growth prospects are declining, it is “generally not a good short-term bet to bet heavily on small caps,” he says.

In 2022, few investors expect U.S. real GDP to exceed 2021’s growth rate, Chan says.

“That suggests that the large caps will outperform small caps in 2022 as U.S. real GDP growth is likely to slow further to 3 to 3.25%,” he says. How Small Caps Perform During Inflation Rising interest rates and inflation affect the margins of all companies, but they also indicate a strong economy.If investors expect the U.S. economy to outperform global trends, small stock exposure could prove to be beneficial, says Steve Sosnick, chief strategist for Interactive Brokers, a Greenwich, Connecticut-based brokerage firm.The flip side is that small-cap stocks “tend to be more idiosyncratic and economically sensitive and thus riskier,” he says. “Bear in mind that the total market capitalization of the Russell 2000 is about $6.7 trillion compared to Apple’s $2.3 trillion market cap. That leaves small caps much more subject to significant inflows and outflows.”Since small caps run the gamut of various industries and have less concentration in sectors like tech, low interest rates “sometimes coincide with weaker economies and inflation may or may not reflect strength in the economy,” Sosnick says. “After those caveats, since small stocks tend to be more economically sensitive, we can assert that small stocks do well when monetary policy is accommodative and do worse when there are external pressures upon the economy.”[ READ: Understand Inflation Before It’s Too Late. ]Using the monthly 10-year yields for the past 20 years, the average monthly return was 1.1% for the S&P SmallCap 600 and 1% for the Russell 2000 in months where interest rates were less than 2.1%, says Jodie Gunzberg, managing director of CoinDesk Indexes at TradeBlock. Both the S&P 500 and S&P MidCap 400 returned 1.1%.Small-cap stocks respond more by how much growth could occur in the U.S. than by a particular interest rate environment, Chan says. If interest […]

source How Small-Cap Stocks Might Affect Your Portfolio in 2022

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