Small-Cap Stocks and the “Trump Bump”

Small-cap stocks have been on a tear since the beginning of November, skyrocketing on election day due to the so-called “Trump Bump.” Since November 1st, smaller-capitalization stocks are up over 10%, almost doubling the return of the S&P 500. This is a much needed boost for the asset class, as small-caps have really lagged their large-cap peers in recent years. We’re still believers in these “little guys” as diversifiers in the long-term, although they can be frustrating in the short-term.

Small-Cap Stocks and the ‘Trump Bump’: What It Means for Investors

The financial markets are no strangers to volatility during election cycles, but the 2024 U.S. presidential election brought a unique dynamic to the fore. Donald Trump’s victory sent shockwaves through Wall Street, sparking a significant rally in the stock market, with small-cap stocks emerging as notable winners. As individual investors, understanding the context and nuances behind these market movements is critical for informed decision-making. Let’s unpack the “Trump Bump,” its implications for small-cap stocks, and what it means for your portfolio.

Small-Cap Stocks: A Post-Election Surge

In the week following Trump’s election, the Morningstar US Small-Cap Index soared 6.7%, outperforming large-cap stocks’ 4.6% increase. The surge was largely attributed to two key factors:

1. Policy Tailwinds: Trump’s proposed policies—focusing on domestic economic growth, deregulation, and tax cuts—were perceived as favorable for small, U.S.-focused companies.
2. Easing Election Uncertainty: The decisive outcome alleviated market concerns about a prolonged or contested election, leading to a “sigh of relief” rally.

These developments ignited optimism among investors, especially in sectors like financials and industrials, which dominate small-cap indices. However, as with any market rally, the question remains: is this momentum sustainable?

Why Small-Caps Led the Charge

Small-cap stocks often serve as a barometer for investor sentiment, particularly during periods of economic change. Their reliance on domestic revenue shields them from international uncertainties, making them more appealing in times of “de-globalization.” Here are some of the driving forces behind their recent outperformance:

1. Financial Sector Boost:
   • Small-cap indices are heavily weighted toward banks and financial companies, which stand to benefit from deregulation and a looser regulatory environment. Reduced oversight can foster lending growth, profitability, and even mergers and acquisitions.
2. Industrial Resilience:
   • Industrial companies, another significant component of small-cap indices, are poised to benefit from Trump’s focus on domestic manufacturing and infrastructure spending. These policy shifts could enhance demand and drive earnings growth for smaller industrial firms.
3. Rotation from Mega-Cap Tech:
   • Leading up to the election, the market began pivoting from tech-heavy large-caps to other sectors, including small-caps. This rotation gained momentum as inflation data cooled in mid-2024, signaling potential Federal Reserve rate cuts—a positive catalyst for smaller, growth-oriented companies.

Interest Rates and Small-Caps: A Complicated Relationship

While the rally in small-cap stocks is encouraging, it coincides with a challenging bond market environment. Rising bond yields, spurred by expectations of stronger economic growth and inflation, have sparked concerns about the impact of higher interest rates on small-cap performance. Here’s why this matters:

• Debt Sensitivity: Small companies often carry higher levels of debt (typically tied to floating rates) relative to large-cap firms. Rising interest rates increase borrowing costs, which can strain profitability.
• Economic Growth Potential: On the flip side, higher bond yields driven by robust economic growth could outweigh the negative effects of elevated rates. In a thriving economy, small caps—being more economically sensitive—may still perform well.

Historical trends provide some reassurance. According to Francis Gannon of Royce Investment Partners, small-caps have historically outperformed large-caps in the months following an initial rate cut. While inflationary risks remain a concern, particularly from potential tariffs, the broader environment suggests room for optimism.

Are Small-Caps Undervalued?

Another factor contributing to the bullish case for small-cap stocks is their relative valuation. Price-to-earnings (P/E) ratios—a key measure of valuation—indicate that small-caps may offer better value compared to their large-cap counterparts. Time will tell if this presents an opportunity for outperformance going forward.

What’s Next for Small-Cap Stocks?

While no one can predict the future (and I’m certainly not 😉) , several indicators suggest that the small-cap rally may have legs:

1. Momentum Indicators:
   • The growing number of small-cap companies reaching new highs signals positive momentum. This trend often reflects underlying strength in the sector and broader investor confidence.
2. Policy Continuity:
   • Despite potential political uncertainty, smaller companies stand to benefit from a stable regulatory and tax environment focused on domestic growth.
3. Attractive Valuations:
   • The relative affordability of small-cap stocks, combined with their earnings potential, provides a compelling case for continued investment.

A Bright Spot and Key Diversifier in Your Portfolio

Small-cap stocks have emerged as a bright spot in the post-election market landscape, driven by favorable policy expectations, easing uncertainty, and a shift in market dynamics. While challenges like rising interest rates and inflation persist, the potential for long-term gains remains compelling.

Here’s why we utilize small-cap stocks as diversifiers in most of our managed portfolios:

• Broadening Your Exposure: Small-cap stocks provide access to a segment of the market that’s typically more focused on domestic growth. This focus can complement the global exposure of larger-cap companies in your portfolio, helping to create a well-rounded investment strategy.
• Tapping into Growth Potential: Small-cap companies often operate in niche markets or emerging industries with substantial growth potential. Historically, they’ve been among the best-performing segments of the market over the long term, even though they can experience more volatility in the short term.
• Capitalizing on Market Trends: In the current environment, small caps are benefiting from policy shifts that favor domestic-focused businesses, deregulation, and infrastructure spending. These trends align with our broader strategy of seeking opportunities across different sectors and market capitalizations.

We understand that markets are always evolving, and small-cap stocks, like any investment, come with risks. However, as part of a diversified portfolio, they can enhance returns and reduce overall risk by balancing the performance of other asset classes. Our approach is to carefully select small-cap investments that align with financial goals, risk tolerance, and time horizon, ensuring they support long-term objectives.

Sources: YCharts, Morningstar

Concerns or questions about how your investment portfolio will hold up in the current market environment? Contact Financial Synergies today.

We are a boutique, financial advisory and total wealth management firm with over 35 years helping clients navigate turbulent markets. To learn more about our approach to investment management please reach out to us. One of our seasoned advisors would be happy to help you build a custom financial plan to help ensure you accomplish your financial goals and objectives. Schedule a conversation with us today.

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