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Small caps could offer great recession protection

On the surface, the Franklin LibertyQ US Small Cap ETF (CBOE:FLQS) may not seem to many investors the ideal way to survive and thrive during a recession. However, some market watchers are bullish on small caps, even against the backdrop of a potentially sharp economic downturn.

In fact, FLQS, which tracks the LibertyQ US Small Cap Equity Index, could be a surprisingly strong consideration for investors looking to stay engaged with stocks during a recession. This is despite the reputation of high volatility of small caps.

Some of the reasons the FLQS could prove durable in a legitimate recession include economists’ expectations that the contraction will be brief and the improving quality of earnings from smaller stocks.

Bank of America Strategist “Jill Hall prefers small caps to large caps: small caps enjoy much better earnings forecasts, have held up better in inflationary/stagflationary environments, and benefit from even better trends in services>goods spending. Jill also thinks they have largely priced in recession risks, with the risk premium for small-cap stocks at record highs and the recent drop of around 80% in the typical small-cap decline around recessions,” according to a recent bank report.

Another point in favor of FLQS is that small-cap stocks have already seen significant peak-to-trough declines, with some of the major small-cap benchmarks outpacing historic recessionary lows. As such, small stocks may already embed more economic contraction risk than their large-cap counterparts. This could signal greater vulnerability to recession for large caps.

“Jill sees the possibility of further declines in small cap stocks in the 5-15% range, where there is more downside potential in large caps (Savita Subramanian’s bottom scenario on the S&P 500 is 3000- 3200, with a year-end target of 3600. Avoiding recession would keep the US in a late cycle regime, which would likely be bullish for small caps,” Bank of America added.

Favorable small cap valuations and the aforementioned improving earnings quality of the group also support the short-term case for FLQS. While valuation doesn’t always propel stocks higher, strong earnings growth is a legitimate catalyst that investors should recognize.

“Small companies also have stronger guidance than their larger counterparts, with an above-average and improving earnings guidance ratio,” Bank of America concluded. “The forecast for small caps is the strongest since 2007 relative to large caps, suggesting that small cap stocks may be better positioned ahead of a mild recession.”

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Opinions and predictions expressed herein are solely those of Tom Lydon and may not materialize. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.