Jefferies Predicts 6% upside for Russell 2000 despite tough period for small caps

Investing.com - Analysts from Jefferies revealed renewed optimism for small caps on Wednesday, despite a challenging period for the market.

In its mid-cap strategy report, the firm has revised its year-end (YE) target for the Russell 2000 upward to 2180 from 2060, signalling a potential upside of 6%.

The firm continues to anticipate flat earnings for small caps, with no changes to its earnings forecast. Amid the turbulence, Jefferies maintains its preference for Cyclicals and Value themes, while keeping the sector allocation unchanged.

The firm anticipates a boost for smaller small caps and favors names with overseas exposure. Growth at a reasonable price (GARP) strategies have begun to yield results, with the firm expecting further progress.

Even though small caps have underperformed this year, Jefferies believes there's a silver lining. If its YE target is accurate, it would imply that the Russell 2000 is trading at 19.6 times the lofty earnings growth consensus of 15.8% for 2025.

The firm acknowledges the underperformance of small caps versus large caps, with small caps constituting less than 4% of the US equity market.

The top five names now account for 3.6 times the entire Russell 2000, a new high, with these stocks trading at a median price-to-sales ratio of 8 times, compared to less than 2 times for the Russell 2000.

However, Jefferies sees several factors that could potentially boost small caps' relative performance. Companies are starting to perceive small caps as undervalued, with M&A activity for the year already at its fifth-highest total ever.

Furthermore, the macroeconomic backdrop is not perceived as detrimental as investors might think. Lower borrowing costs, healthy balance sheets, and easy access to capital all bode well for small caps.

Jefferies anticipates a re-acceleration in earnings growth as the year progresses, with small caps getting closer to large caps. Despite a recent marginal decline in the aggregate growth rate, revision ratios have increased.

In light of the last two presidential election years where the Russell 2000 gained 18.6% in the second half of 2016 and a staggering 41.7% in 2020, Jefferies' raised YE target for the index seems conservative. However, it does reflect a cautiously optimistic outlook for small caps in an otherwise challenging market environment.