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Small caps are cheap...


Small-Caps Break a 76-Year Pattern of Gains After a Midterm Election -- Barrons.com
By Joe Light

Small-cap companies just made history, and not in a good way. For the economy, it's a sign of pain to come, but for investors, it could be setting up an opportunity.

The six-month window after the U.S. midterm elections has typically been an amazing time to invest in stocks, and in small-caps especially, according to the Leuthold Group. But this time around, the Russell 2000 fell 3.5%, marking its first loss in the six months after the midterms since 1946-47. The S&P 500 rose 8.6%.

If history is any guide, the negative performance is bad news for the economy. Small-caps tend to be a bellwether. They sell off before larger stocks as a recession approaches, hit their bottom before the economy reaches its nadir and lead the market out of the slump.

Part of the reason is that they tend to accrue most of their earnings from the U.S. and can't lean on global profits during a domestic downturn. Investors also tend to flee to large, stable companies when they believe the economy will shrink.

The underperformance was especially notable given how well small-caps usually do at this point in the election cycle. Before this year, small-caps had been on a 76-year streak of gains in the six months after a midterm election cycle. In all, since 1926, such periods had been marked by an 18.3% average return for small-caps, according to Leuthold, versus a 13.7% return for the S&P 500.

The theory, according to Leuthold, is that politics are at play. After the midterms, government officials turn their gaze to the more important presidential election. Typically, the money supply expands in the years leading to that vote, Leuthold says, which gives support to small-caps.

The difference this year is that small-caps have also suffered disproportionately from the regional banking crisis that began in early March. Not only are small-cap indexes more concentrated in financial services companies than large-caps, small tech firms were the most exposed to the destruction of Silicon Valley Bank and Signature Bank.

The good news for investors is that the weakness has left small-caps looking especially cheap, Leuthold says.

Small stocks' trailing price-to-earnings ratio is in the bottom 5th percentile of those of the last 30 years. Relative to large-caps, their valuations -- whether looking at earnings or book value -- are at or near multidecade lows.

To take advantage, investors might need patience and a strong stomach. For now, the market seems to be merely pricing in a slowdown in growth or at most a mild recession, and if those calls are wrong, small-caps could continue to suffer.

"It's worrisome (and exciting at the same time) to think about how low some of those figures might go during a recession," Leuthold said in a report.

Write to Joe Light at [e-mail]