Broker Check

Bank of America is touting small-cap stocks for the bull market that will begin next year

November 07, 2022

Let’s see if they are on track. I am ready to change my mix of stocks now that earnings reports are pretty much completed and now that the election is pretty much over. 

“Instead of the large-cap behemoths that dominated the stock market over the past decade, small-cap stocks are poised to lead the market higher next year and beyond,” says Bank of America. 

I believe that is because various dynamics are coming together that have historically favored the smaller, more localized companies found in the stock market. "Secular trends of stagflation, reshoring, localization, fiscal stimulus = small cap bull in 2023," Bank of America's Michael Hartnett said.

He observed that the near two-decade-long trend of the Nasdaq 100 outperforming small-cap value stocks is beginning to roll over in a big way, and it's following a similar playbook seen during the high inflationary period of the 1970s.

"Stagflation continued through late-1970s but once inflation shock of 1973/1974 was over... US small cap entered one of the great bull markets of all-time; small cap stocks to outperform in coming years of stagflation," Hartnett said.

The profits of smaller companies are more insulated from government taxes, and the trend of localization over globalization favors the smaller cohort, as does fiscal stimulus measures. Small-cap stocks are also "price takers not price makers so penalized less by inflation," he added.

Finally, small-cap outperformance often begins at the start of a recession, which Hartnett believes is imminent. Long-term returns for US small-cap stocks during recessions since 1936 averaged 11.7%, compared to just 8.4% for large caps

While small caps present a big opportunity for investors heading into 2023, few are positioned for the move, especially considering that investors are hoarding cash at a rate not seen since the start of the pandemic in March 2020. This is the classic mistake made by individual investors. We will not repeat this mistake. 

Bank of America saw $62 billion flow into cash over the past week, and so far this quarter $194 billion has surged into cash funds. This is typical of market bottoms. It takes patience and a fair amount of courage to stay put when the temperament of the market is so negative. The rewards for doing so are huge. 

So as investors hoard cash and focus on finding the bottom in the large-cap darlings that worked so well over the past decade, the real bull market is likely to be found in small caps going forward. I for one, will be moving about 50% of the managed accounts toward small caps in anticipation of that move.

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