The stock market landscape has always been a theatre of dynamic shifts and turns, with each year bringing its own set of trends and counter-trends. In the early months of 2024, we’ve seen an interesting reversal in the performance of small-cap stocks compared to their large-cap counterparts, as analysed by experts at Goldman Sachs. Let’s delve into the intricacies of this trend, its implications, and what the future might hold for investors interested in small caps.

In a surprising twist to the stock market narrative, the Russell 2000 index, which tracks small-cap stocks, has lagged behind the large-cap Russell 1000 index by approximately 550 basis points (bps) year-to-date (YTD). This marks a stark reversal from the November to December 2023 rally, where small caps significantly outperformed large caps by 800bps. The reasons behind such fluctuations can be multifaceted, ranging from market sentiment shifts to broader economic factors impacting smaller companies more acutely.

Despite the recent underperformance, Goldman Sachs’ analyst Deep Mehta presents a compelling argument for the potential of small-cap stocks. He points out that small caps offering profitable growth at reasonable valuations, relative to historical data, still represent an attractive risk/reward proposition for investors. Specifically, Mehta highlights companies with projected sales growth of over 5% from 2023 to 2025 (CAGR) that also promise EBIT margin expansion. These companies, including YOU, ERJ, VC, and BCO, not only exhibit growth potential but also trade at a discount compared to their 5-year consensus next twelve months (NTM) multiples, making them particularly appealing.

Adding another layer to the analysis, Ryan Hammond examines the equal-weighted S&P 500 Price-to-Earnings (P/E) ratio, which has expanded to 17 times, placing it in the 92nd percentile since 1985. According to Hammond’s top-down model, this suggests that the S&P 500 P/E is trading 13% above what would be considered fair value (15 times). This discrepancy raises concerns about overvaluation and potential risks to the economic outlook, making the small-cap sector even more significant for investors seeking growth opportunities without the hefty price tag of some larger companies.

For investors wary of overvaluation or potential downturns, Goldman Sachs’ options strategists offer a silver lining. They note that downside protection, through various hedging strategies, appears to be attractively priced. This perspective opens up avenues for investors to safeguard their portfolios while still engaging with the market’s opportunities, especially within the small-cap domain.

The current market scenario, with its blend of opportunities and challenges, underscores the importance of thorough analysis and strategic planning for investors. The insight from Goldman Sachs not only sheds light on the current state of small versus large caps but also provides a roadmap for navigating the complexities of the stock market in 2024. As we move forward, the potential of small-cap stocks, backed by strong fundamentals and attractive valuations, may very well become a cornerstone for portfolios looking to maximize growth in a landscape marked by uncertainty and change.