🍟 Revenge of the small fries

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Today, a 5-minute read on the return of small caps (or what I lovingly refer to as small fries). My thoughts on how long they could lead, and why they ultimately don’t deserve all the Wall Street trash talk they’ve endured over the years.

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People talk a lot about the S&P 500, the famed measure of the top 500 largest publicly traded companies.

Why? It’s easy to explain and a viable shorthand to gauge the stock prices of the companies we use and admire.

Look around you. That phone from Apple, that laptop from Hewlett Packard, that tube of toothpaste from Procter & Gamble, that snazzy pickup from Ford. All from companies that are part of the S&P 500.

But if you just watch the S&P 500, you’re also overlooking a large swath of the stock market – and the U.S. economy.

More than 4,500 companies trade on U.S. exchanges, but aren’t big or prestigious enough to be included in the S&P’s exclusive club.

They’re the small fries. And frankly, they’re sick of your trash-talking.

Small caps – the tier of publicly traded companies between $1.2 and $8 billion, according to S&P – have been on a tear lately, beating the S&P 500 by almost six percentage points and the all-star Magnificent Seven by four percentage points since the beginning of August.

They’ve been called unimportant and uninvestable. Some of Wall Street’s loudest voices have said they’ve essentially been left for dead.

But these companies are ready to take their power back.

Maybe.

When I say small caps, I’m referencing another batch of companies that you’re probably familiar with as well. That Peloton bike you huffed and puffed on last night? The Traeger you grilled those burgers on? The Shake Shack milkshake you grabbed for dessert as a little treat for working out? All from small-cap companies.

They’re names we know and love, but they’ve had a tougher path over the past few years. Small caps are typically less profitable and more reliant on debt than their larger counterparts. Not because they’re financially irresponsible, but because they’re usually younger companies trying to scale so they can one day be S&P 500 behemoths.

So in this high-interest rate world, they’ve been pummeled by the punches of higher borrowing, input and (now) tariff costs. And in turn, they’ve lagged large-cap companies by 40 percentage points since this almost-three-year rally began in October 2022.

Not so much recently. Small-cap stocks have had their moments over the past few years, and they’re in the midst of another one as markets prepare for our nerd superheroes at the Federal Reserve to cut interest rates in just a few weeks. If you’ve been bummed out by small caps’ inability to borrow cheap money, you’re probably feeling pretty good about lower rates ahead. Investors sure are.

This happened last year, too. From July to August 2024, small caps beat large caps by five percentage points as late-year rate cuts came into view. Ultimately, the string of cuts was short-lived (thank you, tariffs and inflation concerns), and the small fries eventually ceded their thrones.

But for the most part, the past few years have been dotted by the pain of investor restraint. People simply haven’t had the appetite to bet on up-and-coming names, strained by a gradually slower economy and historically high rates. The vibes have been weird, OK?

Small caps are leading again. I’ll enjoy the moment and cheer for the small fries, but I think success could still be fleeting for our little engines that could.

Not because I’m a hater of progress and new blood. Or because I think small caps are dead forever.

More because we haven’t seen the precise low-rate, high-growth environment that has historically helped small caps shine in a very long time. Really, since the peak COVID days.

Look at this table of small vs. large cap returns in bull (strong rallies) and bear (big drops) markets since the 1920s. Small-cap stocks have led in the first year of every single bull market dating back to the 1930s except the one we’re in now.

Not only have they led. They’ve crushed it.

Small caps have beaten large caps by an average of 41 percentage points in the first year in all bull markets since the 1930s.

Smalls do eventually lose their edge as the bull ages, but they often come firing on all cylinders out of the gate. 

You have to go through a reset of sorts first, though. Markets and/or the economy have to hit rock bottom so that policymakers respond with dramatic action. This unleashes smaller companies, which tend to benefit when the economy’s prospects are significantly better than current conditions.

This time around, the bull started charging when the Fed was increasing interest rates. That’s exceedingly rare. Since the 1970s, most long rallies have started from rate cuts boosting the economy and luring money into riskier assets.

I don’t think we’re in this moment yet. Economic growth may decelerate in the coming quarters, and the Fed can’t cut interest rates too much because of the threat to inflation. Any firepower smaller companies have could be limited unless we get a true economic crisis. And then you’re in a recession, which is the worst-case scenario for stock prices.

One small bright spot is that small caps currently trade at much lower valuations than their larger brethren. If the economy hits a rough patch, we may see the rare stock selloff where small caps weather the storm better than large caps simply because they haven’t run as far.

I also sympathize with those who argue that the universe of small caps has structurally changed due to unicorns and fervent venture capital funding. Yes, businesses are staying private longer, and the best often shoot straight to large-cap status because they go public at valuations much higher than the small-cap cutoff. Successful companies often grow so quickly that they’re small caps for a short period of time, and then they graduate to the mighty S&P 500.

However, we haven’t seen an initial public offering exceed the S&P small cap threshold since 2021, and less than 1% of IPOs since 2008 have been able to do so on day 1 of going public. Plus, in this moment, there are a lot of newly public companies that debuted in the party days of 2021 that are small caps strictly because of the weird environment we’re in. Potential diamonds in the rough, if you will.

To me, small caps are a lesson in recency bias. No, they haven’t worked well for most of the past three years. But do they deserve to be declared dead?

I don’t think so. Small caps have led in 49% of months in the past 50 years. Their long-term track record looks like this:

And to be dead, they have to stop breathing first.

For now, keep the faith in small fries. Even if it takes some patience.

Fight your goldfish brain, and remember what they can do for you if the economy’s fortune turns.

Thanks for reading!

Callie

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