In the investment world, small caps are often an afterthought compared to large-cap and tech-related stocks, even as they quietly fly under the radar. But should investors really be ignoring small caps in 2025?
The most common way to measure small caps is through the Russell 2000, which is a collection of the 2000 smallest firms in the Russell 3000 (which measures the 3000 largest US companies).
Many investors are likely familiar with a few Russell 2000 components, like JetBlue, Krispy Kreme, and Papa John's, but there's a long list of firms they've likely never heard of -- they're certainly not as recognizable as the top Dow or S&P 500 holdings.
In November 2024, the Russell 2000 gained 10.8% for the month. While this is a rare feat -- occurring 22 times since 1980 (or about 4% of the time) -- we've now seen it three times in the last 12 months (December 2023 and July 2024 mark the other occasions).
Historically, this type of strong monthly performance tends to be followed by more gains down the road (more on that in a minute). However, this lumpy performance has been frustrating for investors trying to time the market rather than maintain a constant exposure to small caps.
In the 12 months ending November 2024, the Russell 2000 had gained 34.6% -- outpacing the Dow, S&P 500, and Nasdaq 100.
In a year where markets have generated robust returns, the gains in small caps have largely seemed to go unnoticed. Perhaps that's because of the "boom then idle" price action we've seen over the past year. Or maybe it's because small caps generally get less recognition than their large-cap peers.
It doesn't help that the Russell 2000 has lagged its larger peers from the bear market lows, gaining "just" 51% at the recent highs, lower than the other three major US indices.
No one knows for sure how small caps will perform going forward, but historically, bullish bursts of momentum have boded well for this group.
The table below highlights how well the Russell 2000 has performed six months after the index rallies by 10% or more in a given month. Officially higher in 18 of the previous 20 occasions, the index has historically rallied 90% of the time in these scenarios while boasting an average return of 11.4% during this six-month stretch.
While the historical statistics are favorable for small caps moving forward, so are the fundamentals.
The US economy continues to hum along and the labor market is on solid footing. Further, the Fed is on a path to lower interest rates, which could help small- and mid-cap stocks as their businesses tend to be more rate sensitive. In high-rate environments, these firms have struggled as margins have come under pressure and borrowing has gotten more difficult.
Lastly, earnings growth is expected to be strong. While analysts are forecasting double-digit earnings growth for the S&P 500 in 2025, consensus estimates for the Russell 2000 call for outsized income growth of almost 40%.
Investors should remember that estimates are just projections and educated guesses that can pan out to be wrong. This is just one risk of several that investors face as we turn the page to 2025.
While small caps were a slow starter out of the gate for this bull market, they have really found their groove over the past 12 to 15 months -- even if that performance has been bumpy.
Markets and investors face risks, just as they always do, and they will almost surely face pullbacks throughout the year. But provided that the long-term catalysts outlined above remain in play, small caps may be worth a closer look for investors -- particularly if they've been enjoying big gains in other areas while excluding this group.
The big question is, will small caps finally outperform the S&P 500, something it hasn't done since 2020 and has only done twice in the last 10 years? That remains to be seen.