American small-cap stocks will bounce back

Smaller companies in America will play catch up with their bigger peers.

The US stockmarket as a whole is expensive compared to its history. However, anyone looking to invest in America might want to look at the smaller company index the Russell 2000.

While the S&P 500 blue-chip index is up by around 8% this year, the Russell is little changed. But there's scope for small-cap stocks to play catch up.

Small businesses are at their most optimistic in seven years, with confidence nearing its pre-recession average. That makes sense because small caps are domestically orientated, they benefit most from household spending, which accounts for the lion's share of America's GDP.

And for now at least, the US consumer is in fine fettle. Consumer confidence is also at a seven-year high now that the labour market is rapidly gaining strength. There is talk of this being the best Christmas shopping season since the crisis.

As a result, "we don't expect the divergence between the economic performance of small firms and the small-cap equity market to last long", says Capital Economics.

Another boost for small caps is that they are barely exposed to currency risk, whereas the strengthening dollar undermines the S&P's foreign sales worth around half of total revenues.

A further reason to like small-cap stocks is that their earnings quality is higher, notes Barclays. Since the recovery began, large caps have beefed up their earnings mainly by managing costs smaller companies have focused on bolstering sales.

The Russell 2000 should also benefit from cash-rich blue chips looking to scoop up smaller rivals. Given all this, the Russell seems set to close the gap with its blue-chip rival over the next few months.

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