The recent surge in the Russell 2000 (^RUT) appears to have been premature, according to F.L. Putnam Investment Management Co. chief market strategist and portfolio manager Ellen Hazen. Despite a wide valuation gap favoring small-cap stocks over their larger counterparts, a deteriorating earnings outlook for the segment is casting a shadow over its investment appeal.
Hazen emphasizes that while small-cap valuations may appear cheap on the surface, the underlying fundamentals tell a different story. While earnings revisions for the S&P 500 continue to trend upward, those for small-cap companies have been steadily declining. This divergence underscores the importance of scrutinizing earnings growth prospects when selecting investments.
The anticipated interest rate cut in September is unlikely to provide a significant boost to small-cap performance, Hazen contends. While lower borrowing costs are generally viewed as positive for equities, the impact on small caps may be muted due to their higher leverage. This financial characteristic exposes them to greater vulnerability in a slowing economic environment.
To navigate the complexities of the small-cap landscape, Hazen advises investors to prioritize companies with improving earnings estimates and conservative debt levels. Sectors such as telecommunications, financials, and healthcare are identified as potential areas of opportunity.
In conclusion, the allure of cheap valuations should not overshadow the critical importance of earnings growth and financial strength when investing in small-cap stocks. As the Federal Reserve embarks on a potential rate-cutting cycle, investors would be wise to exercise caution and focus on companies with resilient business models and promising growth prospects.
