Are small cap stocks about to have their moment?
It seems that may be the case…
Considering large caps, as measured by the S&P 500, have done the heavy lifting of the current stock market rally.
And the Magnificent Seven – a group of seven megacap technology growth stocks associated with artificial intelligence – have led the way. Because the S&P 500 is a weighted index, companies with the largest market caps have a bigger impact on it. And all of the Magnificent Seven stocks are among the 11 largest firms in the world.
But the Magnificent Seven’s recent run – as a group, they’re up 230% since the October 2022 beginning of the current bull market – has also made them very expensive.
The forward price-to-earnings ratio (P/E) of the Magnificent Seven now stands at 28.6. That’s far higher than the S&P 500’s P/E (22.2) and nearly double that of the S&P SmallCap 600 Index (just 15.6).
And now, several challenges that have held small cap companies back are receding. So there are suddenly new opportunities in the small cap space.
Rate Cuts Coming
Small companies have suffered from higher borrowing costs since the Federal Reserve started hiking rates in early 2022 in response to spiking inflation.
These companies tend to have less in the way of profits, so they rely more heavily on credit to fund their operations. And credit has been expensive the last few years.
But relief is likely on the way. It looks increasingly likely that the Fed will begin reducing rates later this year.
Futures traders are now pricing in at least two quarter-point rate cuts by the end of the year, and possibly three.
And historically, small caps have benefited the most during interest rate easing cycles.
Since 1954, small cap stocks gained on average 14.2% after the first Fed cut, while large caps gained 9.4%. And a year after the first cut, small caps gained nearly 27% while large caps rose about 16%. An 11-percentage-point outperformance is pretty significant for any asset class.
Lower Taxes
The recently-passed One Big Beautiful Bill Act extends the corporate tax cuts enacted during President Donald Trump’s first term.
That’s more good news for smaller businesses, which tend to pay higher tax rates than their larger brethren due to their revenue composition. They rely more heavily on domestic revenues, which are more directly affected by U.S. corporate tax rates.
Tariffs
Finally, tariffs disadvantage bigger firms, because those businesses get more of their revenue from exports than small firms, which tend to be more domestically focused.
And while the Trump administration is negotiating many of the tariffs down, they will still be higher going forward. This gives small firms a leg up on large caps.
Put higher tariffs, lower taxes, and more affordable borrowing costs together, and the future is looking bright for small businesses and their share prices.
And in fact, we’re already seeing that in our portfolios at The Oxford Club.
The truth is the surge in small cap stocks is already here – if you know where to look.