RBC Capital analysts are urging caution with U.S. small-cap stocks, saying it’s best to “stay on the sidelines for now.” In a note, the investment bank highlighted a less promising near-term outlook for small caps, citing several factors.

Chart: Benzinga Pro

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RBC: Decoupling Is Underway, Neutral For Now

The continued outperformance of mega-cap growth stocks has been logical but somewhat jarring to RBC, especially as Treasury yields have declined, historically benefiting small caps. However, RBC suggests a decoupling is underway, as reported by the website Investing.

Factors contributing to the outsized performance of large-cap growth stocks (making it more attractive) include:

• Slowing GDP forecasts,
• More positive recent earnings revisions
• Reduced crowding in the large-cap growth sector

Despite acknowledging the recent weakness in small caps, RBC remains neutral on the sector relative to large caps.

The company recognizes the historically favorable positioning of small caps based on investor sentiment and valuation metrics. However, RBC cautions these factors are outweighed by the lack of fundamental tailwinds and negative earnings revision trends for small caps.

RBC suggests a wait-and-see approach, stating, “We see enough that looks interesting to stay neutral for now and think that when it’s finally time to put on Fed rate cut trades this space will do well.”

UBS: Strong Potential For Small Caps, Expect Outperformance In Near Term

On the other hand, UBS analysts are more optimistic about the potential for small-cap stocks in the coming months. They predict strong potential for small caps, citing a historical correlation between small-cap performance and Treasury yields, as reported by Investing.

Over the past year, small-cap stocks have outperformed when Treasury yields have declined, notes UBS. Conversely, small caps have underperformed during periods of rising yields. Historically, when this relationship deviates, a correction quickly follows.

UBS points to a significant outperformance of small caps in early February following a disconnect, similar to the current situation where large caps are outperforming despite falling interest rates since May.

“This represents the potential for mid- to high-single-digit small-cap outperformance over the near term,” concludes UBS, suggesting a significant upswing for small-cap stocks in the near future.

For investors seeking diversified exposure to small cap equity, the iShares Core S&P Small-Cap ETF IJR, the iShares Russell 2000 ETF IWM and the Vanguard Small Cap ETF VB are popular ways.

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