SmallCap Value stocks have dramatically underperformed the S&P over the last 5 years with the S&P up 102% and small-cap value stocks up only 53%. This underperformance has resulted in a large valuation gap with small-cap value stocks trading at only 16x 2024 EPS estimates and 12x 2025 vs. the S&P at 19.4 and 17.5x. This valuation gap exists even though small-cap value stocks have almost double the growth rate of the S&P 500. In addition, the average dividend yield of the small-cap value index is 2.5% vs. the S&P 500 at 1.6%.
We believe that small-cap value stocks are an attractive asset class that should be represented in diversified portfolios. The small-cap value sector increases portfolio diversification as it is less correlated with the broad market with an 83% correlation to the S&P vs. large-cap sector funds such as the Dow or Nasdaq 100 at a 96% correlation. In addition, small-cap stocks generally have superior growth prospects as they are in the earlier stages of the business life cycle. Also, smaller companies are often attractive acquisition targets for medium to large-cap companies. Finally, small caps have less analyst coverage, providing an advantage for active management.
Small-cap companies are perceived to be more interest rate sensitive than large-cap defensive companies as they generally have higher debt levels and rarely have net cash positions as some large-cap technology companies do. Over the last two years, small caps have underperformed larger cap companies as interest rates rose substantially driven higher by restrictive monetary policy. Year-to-date small-cap stocks have underperformed the S&P by 10% despite outperforming since the peak in rates that occurred in late October. Small-cap value stocks have, however, outperformed large-cap companies over the last 20 years, indicating that small-caps are an attractive asset class for long-term investors.
We are forecasting that 2024 will be the Year of Global Rate Cuts, as every OECD country except Japan is expected to cut interest rates by an average of 1.25% as implied by global interest rate futures markets. We believe that international central banks are likely to lead the Fed in rate cuts as overseas economies are far weaker than the US, with the Euro Zone currently in a recession with Q4 GDP tracking at negative 1.6%. We are forecasting that the US 10-year treasury rates drop into the 3-3.5% range in response to global rate cuts and the related expansion in the global monetary base. We forecast that the declining rates and the increase in global liquidity will drive the S&P to 5,500 based on 20.5x 2025 estimated earnings of 270.
We believe that small-cap value stocks are a timely investment and are likely to outperform the S&P 500 in 2024 due to upside during periods of declining interest rates, the fundamental attractiveness of the sector, and their current valuation discount with less correlated returns.