Small-cap US stocks powered back in the fourth quarter after trailing large-caps for several years. Even after the strong recent performance, the recovery may still be in its early stages—particularly for smaller-cap value stocks—as pandemic risks recede and earnings drivers kick in during 2021.

Both small-cap stocks and value stocks have underperformed the broader market by extremely wide margins in recent years. From 2017 to September 2020, the Russell 2000 Value Index of small-cap stocks trailed the Russell 2000 Growth Index by 58% and underperformed large-cap growth stocks by more than double that (Display, left).

Two bar charts showing performance for Dec 2016 to Sep 2020 and Q4:20 of small cap and large cap growth and value indexes.

Things started to change in the fourth quarter of 2020 (Display above, right). As news of COVID-19 vaccine successes raised hopes of a broader economic recovery in 2021, investors started to move back into stocks that are considered more sensitive to the economic cycle. As a result, US small-cap value stocks advanced by 33% in the fourth quarter, outperforming growth stocks and the broader market.

Is the Small-Cap Value Rally Over?

After such a sharp recovery, have investors missed the opportunity? We don’t think so. By understanding why small-cap stocks underperformed over the past four years and what’s changed, we believe investors can gain confidence in the recovery potential. Since the small-cap slump of recent years was so dramatic, the late 2020 rebound has only recovered a small amount of the underperformance. And there are good reasons to expect smaller, attractively valued companies to do well as the macroeconomic recovery progresses this year.