Are Small Caps Poised To Lead The Market? Experts Weigh Pros, Cons

Small-cap equities could be the dark horse of the next 10 years after the previous decade saw an outsized return from the U.S. large-cap sector.

The latest Vanguard market perspective highlights the U.S. small-cap sector as the leading domestic opportunity, projecting an annualized return between 5% and 7%, with a caveat of the median volatility of 22.6% — the highest among the listed domestic sectors.

The report highlighted the resolution of the disbalances in the labor market as an aftershock of the COVID-19 pandemic.

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"Our non-accelerating inflation rate of unemployment estimate suggests that the labor market has reached a healthy balance," said Adam Schickling, a Vanguard senior economist, adding that they expect additional rate cuts but hold no expectations for the near-term labor market conditions prompting an accelerated cutting cycle.

Going into 2024, Vanguard called small-cap stocks "attractive in the long term," while Fidelity is even more optimistic, expecting rate cuts to provide an attractive environment. Looking at the year-to-date returns:

The S&P 500 is up 22.9%, while the small-cap-focused Russell 2000 is up around 11.4%.

Small-Cap Mean Reversion

"Mean reversion is a concept we believe in—it's one of the fundamental principles of long-term investing. But it's crucial to remember that the timeline for mean reversion isn't predictable. It might happen in the next decade as they predict, or it could take longer, even up to a hundred years," Creative Planning‘s Chief Investment Officer James Battmer recent noted.

These predictions are generally not enough of a catalyst for portfolio re-adjustments.

In the video below, Chief Market Strategist Charlie Bilello listed gains from leaders like Nvidia, Tesla or Netflix, but Battmer argued that continuing the same trajectory is unlikely.

"If they were to replicate the same growth, they'd be larger than the entire U.S. economy, which is a near-impossible scenario," Battmer noted.

Even so, talking about the first decade of this century, he showcased what the "lost decade" for large-cap growth looks like.

"If you had invested a million dollars in a growth-focused portfolio, you'd have lost around $333,000 over that 10-year span," he said, pointing out the importance of owning a broad range of stock and not just the "big winners."

Vanguard Total Stock Market ETF VTI is up 21.75% year-to-date.

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