Morgan Stanley Backs Small-Cap Rotation as Goldman Says Go Big

(Bloomberg) -- A promising October for small-cap stocks hit a speed bump Monday as a powerful rally in tech giants left everyone else behind. For investors seeking advice on whether now is the time to rotate asset classes, two prominent Wall Street prognosticators are split.

Goldman Sachs Group Inc. strategist David Kostin says the backdrop favors going big, with the five largest technology firms poised to report earnings growth in the third quarter amid a drop in profit for members of the small-cap Russell 2000 Index.

His counterpart at Morgan Stanley, Mike Wilson, disagrees. He prefers smaller companies, saying their earnings prospects are improving faster thanks to a recovering economy. Analyst estimates for next year’s profits have risen 17% in the past three months for small-caps, way ahead of a 1.8% increase for the large-cap S&P 500 Index, the firm’s data show.

“They saw sharper cuts to their numbers in the wake of the pandemic and it makes sense to us that they will see a more powerful recovery,” Wilson wrote in a note to clients. “This observation is core to our recommendation to favor small-cap cyclicals.”

The U.S. stock market in 2020 has been dominated by the large tech companies amid bets that they are better positioned for the stay-at-home economy than counterparts dependent on person-to-person contact. But investors are questioning how long the outperformance can last after the tech-heavy Nasdaq 100 surged more than 30% this year, compared with a slight decline for the Russell 2000.

Following their advice has yielded mixed results. While Wilson’s August call for a market correction proved prescient, his warning that the Nasdaq 100 might tumble more than 20% didn’t bear out. Similarly, while Kostin’s persistent bullish stance on tech shares has paid off for investors, his prediction in May that the S&P 500 could post another slump turned to be too pessimistic.

The Russell 2000 added 0.3% as of 2:26 p.m. New York time, trailing the S&P 500’s advance by more than 1 percentage point. The five largest stocks by value -- Apple, Microsoft, Amazon, Facebook and Alphabet -- each rallied at least 3%. Apple is holding a product event Tuesday at which it’s expected to unveil new iPhones and Amazon will kick off Prime Day.

It’s a turnaround from the previous two weeks, when small-caps outperformed, bolstered by speculation that more fiscal stimulus was on the way. Despite a day of lagging returns, the Russell 2000 has beaten the S&P 500 by almost 4 percentage points in October, poised for its best month of relative return in three years.

But investors may be better off leaning toward large companies as earnings season kicks off this week, according to Kostin. Profits for the big five probably grew 1% in the third quarter, compared with a 40% plunge for companies in the Russell 2000, analyst estimates compiled by Goldman showed.

“Large-cap stocks appear better positioned for 3Q than small-cap stocks,” Kostin wrote in a note to clients.

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