Tempted to go bargain-hunting for small-cap stocks? Why you might want to wait.

See: Wall Street veteran sees ‘once in a generation buying opportunity’ in unloved areas of global stocks

But as the old Wall Street adage goes, just because something is looking cheap, doesn’t mean it can’t get cheaper. Two Wall Street equity strategists who spoke with MarketWatch said that small-caps will likely continue to struggle so long as interest rates at, or near, current levels.

“This trade is going to get more stretched literally up until we have a strong positive Treasury yield curve and Fed rate cuts of 100 basis points,” said Manish Kabra, head of U.S. equity strategy at French bank Société Générale, in an interview.

Perhaps the biggest obstacle facing small-caps is that roughly one-quarter of Russell 2000
RUT
constituents are unprofitable. Even those that make money sport margins that are far more modest than their large-cap peers.

“Many of the stocks in the Russell 2000 are marginally profitable, or even unprofitable. It certainly makes sense why you would see better performance from stocks that make money, than not,” said Steve Sosnick, chief market strategist at Interactive Brokers, in a phone interview.

That being said, signs that the Federal Reserve might slash interest rates in 2024 are offering a glimmer of hope for struggling small-caps just as the ratio between the Nasdaq-100 to the Russell 2000 has climbed to a fresh record high as of Wednesday, according to Dow Jones Market Data.

The Russell 2000 logged its best performance since February 2021 last week as stocks soared on hopes that the Fed could start slashing borrowing costs later next year. The small-cap index outperformed the Nasdaq Composite
COMP
and S&P 500
SPX,
an increasingly rare occurrence.

Small-caps outperformed the Nasdaq in 2022 as stocks stumbled. But they have largely missed out on this year’s rebound rally. The end result is that the Nasdaq is outperforming the Russell by 32 percentage points so far in 2023, according to David Rosenberg, the former chief North American economist at Merrill Lynch and founder of Rosenberg Research. That is the largest margin of outperformance since 1999, shortly before the peak of the dot-com bubble.

Weakness in the Russell has been widespread among its components, a majority of which are trading in bear-market territory. Of the 1,970 stocks in the index, 72.1% are down 20% or more from their 52-week highs, according to Dow Jones Market Data.

Small-caps’ valuation based on expectations for corporate profits are low. But they have been lower in the not-too-distant past.

The forward price-to-earnings ratio for the S&P 600
SML,
a small-cap index that excludes many of the unprofitable companies included in the Russell, stood at 12 on Wednesday. But it had fallen as low as 8.7 in March 2020, while briefly dipping below seven in November 2008, according to FactSet data.

“These stocks are cheap, but they are not totally bombed out,” Kabra said.

Nicholas Colas, the co-founder of DataTrek Research, showed that periods of small-cap outperformance have grown less frequent over the past 20 years.

According to Colas’ analysis, the Russell 2000 has underperformed the S&P by 19.7 percentage points over the past year, a degree of underperformance that he described as very unusual.

However, over the past two decades, stretches of S&P 500 dominance have grown more frequent, while the margin of outperformance has grown larger. Colas illustrated this in the chart below.

Colas remains optimistic about the prospect for small-caps to make a comeback, and perhaps outperform big tech and other large-cap stocks. But he recommended that clients hold off for just a little while longer before diving in.

“We think it is too early to swap into small-caps, however. Year-end looks like a better time to us,” he said.