Small stocks may thrive in 2021 — no matter who wins the election

The stock market is, to put it mildly, having a strange year.

Posted Updated

Paul R. La Monica
, CNN Business
CNN — The stock market is, to put it mildly, having a strange year.

The S&P 500, a market cap weighted index heavily influenced by the FAANGs, is up nearly 4% in 2020 while the tech-laden Nasdaq has soared more than 20%. But the Russell 2000, the index that is home to America's small cap public companies, is down almost 8%.

And some strategists think 2021 might finally be the time for the Davids of the market to start outperforming the massive Goliaths of tech.

This year, smaller companies are taking the hit: They tend to have more exposure to the United States economy versus overseas markets, and America is in the midst of a recession while facing a possible second wave of Covid-19 cases.

Meanwhile, multinational tech giants like Apple, Amazon, Microsoft, Google owner Alphabet and Facebook, are currently benefiting from the nascent recovery abroad as Europe and Asia move past the worst of their coronavirus outbreaks.

But this tech rally won't last forever: "The run-up we've had in large caps and big tech has been so big that a rotation into small caps is going to happen," said Dan Pipitone, co-founder of TradeZero America, an investing app similar to Robinhood.

"The election is traditionally a dynamic catalyst for this — and it could be more pronounced this year," he added.

Smaller companies outperform in post-election years

Small caps often do well just after a presidential election in party because there's a renewed focus on domestic issues. After the contentious political race is finally over, the president and Congress can actually get down to the real business of governing.

The average return for the Russell 2000 is 15% in the year after a presidential election since 1980, according to research from Citi strategist Scott Chronert. That's about 4 percentage points better, on average, than large cap stocks.

And if the current polling turns out to be accurate and Joe Biden defeats President Trump, small caps could get a particularly big boost. That's because, as Chronert points out, the economy has often slumped in an election year — which means a new president needs to focus on fixing that.

"Since 1980 four elections, and party changes, have taken place during, or related to, recessionary conditions," Chronert wrote in a report late last month.

With that in mind, Chronert thinks the president — be it Biden or Trump in a second term — will need to prioritize issues like tax and trade policies, health care reform and Big Tech oversight to get the US economy back on track.

Other market experts are also predicting that smaller companies will rebound in 2021.

"Small caps definitely could do better next year. They've lagged versus blue chips and usually in a recovery, small caps...lead," said Todd Lowenstein, managing director and equity strategy executive of The Private Bank At Union Bank.

Assuming that the economy is still weak after November, which seems like a safe bet, Lowenstein is cautiously optimistic that Democrats and Republicans will finally work together on more stimulus.

"Small caps should be beneficiaries after the election. Fueling the domestic economy should be an easy win and provide some common ground for bipartisanship," he said.

Of course, that may be easier said given the rancorous state of national politics.

Investors will need to be selective with small caps

Meanwhile, smaller companies face another pressing concern. Several weaker companies — those with lots of debt, in particular -— may not be able to stage a comeback.

"Yes, small companies can do well after election, But the universe of smaller firms has shrunken," said Judith Lu, CEO and founder of Blue Zone Wealth Advisors.

"The market is weeding out small and midsized companies now due to Covid. Companies that don't have strong enough balance sheets may not survive," Lu added.

That's why investors may need to pick and choose their spots wisely. Not all small companies wlil do well. Lu said the key is to look for companies that have attractive valuations — those trading at discounts to larger tech firms.

Growth stocks may also continue to outperform value stocks.

"Interest rates are exceedingly low and that's likely to continue. That favors growth stocks," said JoAnne Feeney, portfolio manager with Advisors Capital Management.

Feeney said she looks for rapidly growing companies that have businesses which are comparable to larger, more well-known stocks.

For example, her firm has a stake in StoneCo, a Brazilian payments firm that's similar to PayPal, as well as financial tech firm Q2. Feeney said her firm has also invested in handheld barcode reader maker Zebra as a way to capitalize on the explosive growth of Amazon and e-commerce, as many workers in Amazon warehouses use Zebra's scanners.

TradeAmerica's Pipitone said his firm's clients are starting to gravitate toward smaller biotechs that could benefit from vaccine news or partnerships with Big Pharma. Vaxart and iBio are two in particular that have soared thanks to strong demand from mom-and-pop retail traders.

Investors are flocking to consumer staples companies too as more people stay home — like booze. Pipitone said Sam Adams owner Boston Beer is a popular stock among TradeAmerica customers.

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