On Friday, BofA highlighted that the Russell 2000 index is currently undervalued following a significant selloff last month. The forward price-to-earnings (P/E) ratio for the index has dropped from 15.8 times to 14.5 times, which is below its long-term average of 15.2 times. According to BofA, this positions small caps to potentially outperform in the coming decade.
Small caps are trading around 5% below their historical average, setting the stage for a strong performance relative to large caps. The current relative P/E ratio of small versus large caps is 0.73 times, compared to the long-term average of 1 times. BofA's analysis suggests that the Russell 2000 could deliver 10% annualized returns, in contrast to the 3% expected for the Russell 1000.
Earnings reports have been favorable, with the majority of small and mid-cap companies surpassing Q1 consensus estimates by 5%. Despite a year-over-year decline of 20% in earnings for small caps, a manufacturing recovery is underway which may further support growth. Additionally, more companies are providing guidance above consensus expectations than below.
BofA recommends a strategic focus on value stocks over growth stocks within the small and mid-cap (SMID) space, advising investors to prioritize P/E ratios over price/earnings to growth (PEG) ratios. Cyclical sectors, particularly Industrials and Energy, are favored in BofA's small-cap quantitative framework.
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