Divergence Creates a 'Good Setup' for Small-Cap in 2025: Strategist

Ever since the large-cap S&P 500 surged to all-time highs while the small-cap Russell 2000 remained stuck in a bear market, a big question has loomed over the potential for small-cap stocks: What would drive their recovery? The answer: Divergence, writes The Times’s [Investment Strategist] and [DealBook’s] [Investment Analyst]. But that setup could lead to significant opportunities for investors.

The S&P 500 has soared to record highs, up more than 2% from its previous record highs in early 2022, while the Russell 2000 remains down more than 20% from its record highs in late 2021. This divergence has never happened before in the stock market's history, presenting a unique opportunity for small-cap investors.

Historically, when the S&P 500 was at all-time highs while the Russell 2000 was in correction territory, small caps rallied furiously over the next year. This phenomenon has occurred three times in the past, and if stocks behave the way history suggests, prudent investors could bank some hefty profits.

Small-cap stocks have historically traded at lower valuations than large-caps, with price-to-earnings ratios near their long-run average and relative P/E multiples looking low. As earnings recover and valuation dislocations normalize, small-cap stocks may experience a re-rating, leading to a catch-up in performance. This is supported by the fact that small-cap P/E multiples are currently 11% below their long-run average, while large-cap P/E multiples are near their long-run average.

The trend of reshoring manufacturing and supply chains back to the US is expected to benefit small-cap stocks more than large-caps. This is because small-cap companies are more leveraged to domestic investment and economic cycles. Additionally, lower interest rates and reduced political uncertainty may lead to an increase in M&A activity, further boosting small-cap performance.

Sector-specific trends and performance differences between large-cap and small-cap stocks are also expected to drive their divergence in 2025. For example, small-cap stocks in the consumer discretionary sector may benefit from a rebound in big-ticket consumer spending, as seen in the examples of LCI Industries (NYSE: LCII), Brunswick Corporation (NYSE: BC), and Pool Corporation. Meanwhile, small-cap stocks in the consumer staples sector may continue to perform well due to their defensive characteristics and exposure to essential goods.

The increased volatility in 2025 may present opportunities for small-cap stocks to outperform, as they tend to be more volatile than large-caps. This is supported by the historical precedent of small-cap stocks rallying furiously over the next year when the S&P 500 was at all-time highs while the Russell 2000 was still in correction territory.

In conclusion, the divergence between large-cap and small-cap stocks, driven by factors such as valuation dislocations, reshoring and M&A trends, sector-specific performance, and volatility, creates a 'good setup' for small-cap stocks in 2025. These factors, supported by specific examples and data from the materials, highlight the potential for small-cap stocks to outperform in the coming years. Investors should consider taking advantage of this opportunity by allocating a portion of their portfolio to small-cap stocks through low-cost ETFs such as the Vanguard Russell 2000 ETF (VTWO) or the SPDR Portfolio S&P 600 Small Cap ETF (SPSM).