The stars appear aligned for small caps

The bull run of recent years has not been quite so rewarding for small-cap stocks as for their larger cap peers. Since inflation first picked up in June 2021, the S&P 500 has risen nearly 50%, while the Russell 2000 has advanced only 9% over that period. Cyclical and political developments make the coming year a time when that may change.

Valuations and market dynamics Small-cap stocks continue to have some of the cheapest valuations ever seen versus large cap (Russell 2000 index at a P/E multiple of 17 versus the S&P 500 near 21). This gap is likely to close if the market broadens out with the arrival of a more business-friendly administration. The Trump administration's deregulatory efforts, in particular, should help small businesses, which often struggle more than their larger counterparts to handle the regulatory burdens imposed by government.

Mergers, acquisitions and IPOs Mergers and acquisitions should pick up with a pro-business Federal Trade Commission and a more aggressive push for innovation. A lighter regulatory hand and lower rates would tend to help the IPO market as well. Additionally, Trump's domestic orientation should help small caps since, as a group, their businesses are more domestically focused than large caps. The IPO market should open up as deregulation continues, the Fed halts rate increases, and the venture capital bubble pops, leading more companies to seek public capital.

Cyclical benefits The case for the timeliness of small caps extends beyond politics. From a cyclical point of view, small caps are among the primary beneficiaries of lower rates, as their funding options are narrower than those available to large caps. When the Fed cuts rates, small caps normally have benefited, showing better performance, Credit Suisse has noted, than mid and large caps in the three, six and 12 months after the first cut, with the small growth subset often doing particularly well.

Earnings recession and recovery Many small-cap sectors have endured an earnings recession since 2022, with the S&P small cap index and its components struggling to string together a net positive growth in earnings. This is finally expected to change in 2025. Small caps typically have enjoyed particularly robust recoveries after a downturn.

Health care and biotech The announcement of Robert F. Kennedy, Jr. as President-elect Donald Trump's nominee to run the Department of Health and Human Services prompted a quick selloff in Health Care and Biotech stocks. Investors worried that Kennedy's opinions on health would be a damper on profits and innovation in the sector. This is reminiscent of prior selloffs, such as that of 2016, when anxiety about Trump and Hillary Clinton's pronouncements briefly overwhelmed promising fundamentals. Biotechs saw solid outperformance in the following years.

Within small-cap stocks as a whole, few industries have been hit harder than Biotech, where stock prices are still more than a third below their early 2021 highs even though fundamentals remain intact. Typically, Biotech names have been particularly strong when rate cuts begin as their financing comes externally.

Future prospects We believe the fundamentals in Biotech significantly outweigh whatever effect a cabinet secretary in the incoming administration may have. There are innovative new catalysts on the horizon as well. What better use can there be for our new AI tools than in the drug discovery process with the hope of saving lives?

Small caps of all varieties stand to benefit from less regulation, lower rates, a domestic focus and an increase in mergers and acquisitions. Additionally, Biotechs have not really participated in the bull market. If that turns around, expect to see strong returns in the space.

Reshoring and domestic production Reshoring and domestic production will be a boost to productivity investments, helping small caps compete globally.