Underperforming the market for 6 years, U.S. small and mid-cap stocks are launching a major comeback! JP Morgan: 30%-60% excess returns may be expected in the next 3-6 years

After several years of significantly underperforming the market, U.S. small-cap stocks are at a critical market turning point, poised to benefit from both valuation recovery and macro-driven dual dividends.

According to news from the Wind Trading Desk, Eduardo Lecubarri, the global small-cap stock strategist at JP Morgan, stated in a research report released on the 21st that U.S. small-cap stocks are expected to achieve excess returns (Alpha) of 30% to 60% over the next 3 to 6 years. He emphasized that since the peak in 2021, the Russell 2000 Index has fallen 60% relative to the S&P 500 Index, marking the largest historical relative gap outside of the tech bubble period, creating a valuation discount close to historical highs.

The core driving force behind this optimistic outlook is the dramatic change in the macro environment: the two headwinds of soaring interest rates and wage inflation that previously suppressed small-cap profitability have now turned into tailwinds. Meanwhile, the tax reduction commitments for domestic manufacturers in the U.S. and the potential impact of tariff policies have created a unique policy environment favorable to domestic demand-oriented small enterprises.

As funding costs are no longer low and the buyback efforts of large companies have weakened, the market landscape is being reshaped. JP Morgan believes that considering this asset class has been under negative sentiment for four consecutive years and typically shows resilience in declining markets, the current moment holds significant upside potential for small-cap stocks.

Historic Valuation Discount

According to JP Morgan's data, U.S. small-cap stocks have significantly underperformed large-cap stocks over the past few years, a performance disparity that is extremely rare in history. Lecubarri pointed out that aside from the tech bubble period, this is the largest degree of underperformance he has seen historically.

Specific data shows that since the peak in 2021, the relative performance of the Russell 2000 Index, which represents small-cap stocks, has fallen 60% relative to the S&P 500 Index. This prolonged slump has led to a severe valuation discount, with current discount levels approaching historical highs.

The report analyzes that the fundamental factors that previously posed significant resistance to small-cap stocks from 2021 to 2023 have now transformed into favorable factors driving growth. This shift is primarily reflected in the dimensions of interest rates and wage inflation.

First, the change in the interest rate environment. Rising interest rates previously impacted small-cap stocks quickly by increasing interest expenses, as these companies often hold more floating-rate debt and have to mark their interest expenses to market more rapidly. Currently, the market expects interest rates to decline rather than continue to rise, which will significantly alleviate the financial burden on small enterprises.

Second, the cooling of wage inflation. As a sector that is far more labor-intensive than large-cap stocks, small-cap stocks were heavily impacted by wage inflation in 2023. However, the U.S. hourly wage growth rate has fallen from a peak of 5.9% in 2022 to the latest 3.7%. With these two suppressive factors becoming a thing of the past, the earnings outlook for small-cap stocks will see substantial improvement

Policy Dividend: Tax Cuts and Tariff Exemptions

In looking ahead to next year's policy environment, JP Morgan has pointed out a unique equation favorable to small and mid-cap stocks: the dual impact of tax cuts and tariffs.

On one hand, the tax cut commitments aimed at domestic manufacturers mean that companies primarily engaged in domestic operations will benefit more than multinational companies, and the business model of U.S. small and mid-cap stocks is inherently more localized. On the other hand, U.S. mid-cap stocks are better protected regarding tariff issues. This is not only because their revenue exposure is more domestic, but also because their sourcing is more localized.

Lecubarri's analysis indicates that if a company's exports exceed its imports, its profit margins will be negatively correlated with the dollar's movements. Due to their lower dependence on overseas markets, small and mid-cap stocks are better able to avoid the impacts of tariffs and exchange rate volatility risks compared to large-cap stocks. This characteristic of "tariff immunity" combined with the "benefits of tax cuts" places them in a favorable position in the new policy cycle.

In addition to the fundamentals and policy aspects, the dynamics of market funding are also changing, particularly regarding the trend of stock buybacks. Over the past few years, stock buyback activities have been very strong, primarily executed by U.S. large-cap companies.

However, as the interest rate center rises, the cost of capital is no longer "free," and with profit growth falling back to single-digit levels, companies' ability to repurchase shares is constrained. According to JP Morgan's observations, the proportion of companies conducting stock buybacks has declined for the second consecutive year by 2025. This trend indicates that the advantage previously enjoyed by large-cap stocks, supported by massive buybacks to prop up stock prices, is weakening, further balancing the competitive relationship between small and large-cap stocks