When my kids were little, one of their favorite books was The Little Engine That Could. Against all odds, that Little Engine climbed the hill and pulled the heavy load over the mountain. It wasn’t always assured that the Little Engine would make it, but it got there. It kind of feels the same with smaller public companies in markets these days – often referred to as “small caps”.

The large company indexes have recently been hitting record highs powered by the so-called “Magnificent 7”.[1] Meta’s stock recently saw an eye-pooping one-day gain of over 20% when it posted blowout earnings numbers. It was apparently the largest one-day gain in the market capitalization of any one company in the market’s history (i.e., market capitalization is total shares outstanding multiplied by share price). Meanwhile, small caps continue to trail their large counterparts. These little locomotives are getting no respect. They remain about 20% from their all-time record highs. But they’ve been perking up, so I wonder if things are turning.

My sense is that small caps could rally strongly once the Fed begins cutting the short-term interest rate. This is not a prediction – as Mr. Market tends to make people look foolish when they make predictions. But there are reasons for small-cap optimism. According to Goldman Sachs, “January 19th marked the first time in history that the S&P 500 hit an all-time high while the Russell 2000 was in a bear market.” (emphasis added). They go on to note that this type of market action is historically positive for both small and large companies with small companies outperforming large companies.

There are various stated reasons why small caps are getting no respect. First, they rely on bank financing more than large companies, and their borrowing costs are higher than for large companies. In addition, large companies tend to hold up better in market downturns, and the risk of recession has certainly been on the minds of investors over the last couple of years.

Price matters, and my adult memory reminds me to be cautious around high valuations. The Magnificent 7 are currently expensive from a price-earnings standpoint. Their prices may end up being justified if earnings continue to impress. But they certainly are not a bargain at the moment – but small caps might be. According to John Hancock Investments, small companies are trading at an 18% discount to their historical price-earnings ratio over the last 20 years while the S&P 500 is trading at a 27% premium, driven in large part by large growth stocks.

I believe it’s important to always maintain exposure to small caps given their historic growth potential to outperform large caps. Plus, they can be effective diversifiers in portfolios. If the “soft landing” or even “no landing” scenario happens this year with the economy, I like the chances of small caps surprising to the upside and pulling the heavy load over the mountain. They might even do just fine in a mild recessionary environment if the Fed is cutting the short-term interest rate considering that they are already trading at a discount.

Bottom Line: if inflation stays under control and the Fed begins cutting the short-term interest rate, I like the potential of smaller companies to rally strongly. As always, stay patient, stay disciplined, and stay invested.

[1] Apple, Amazon, Alphabet, Meta Platforms, Microsoft, Nvidia, and Tesla.