Investing.com -- According to a note from Bank of America, multiple expansion continues to be a key driver of returns in small and mid-cap stocks, though the outlook for earnings recovery remains uncertain.
The bank said that in September, the price-to-earnings (P/E) ratios for small, mid, and large-cap stocks expanded, with the Russell 2000's forward P/E rising to 15.8x, just above its historical average of 15.2x.
Similarly, the Russell MidCap P/E rose to 17.8x, and the Russell 1000 reached 21.5x, placing them both above their long-term averages, according to BofA.
Despite small caps now trading above average on all metrics BofA tracks, including P/E, price-to-book, and EV/FCF, the analysts expressed caution regarding near-term fundamentals.
The bank adds that the Russell 2000 continues to show weak earnings growth, and BofA’s U.S. Regime Indicator has shifted further into a "Downturn" phase, where small caps historically lag behind large-cap stocks.
Over the long term, the relative P/E ratio of the Russell 2000 to the Russell 1000 has fallen to 0.73x, about 30% below its historical average.
BofA suggests that small caps could offer attractive long-term returns, with projected annualized gains of 9% over the next decade, compared to just 1% for large caps.
However, in the near term, BofA favors mid-cap stocks over small caps due to better earnings revision trends and more positive guidance.
"Near-term, we favor mid over small: mid caps have better revision/guidance trends, have historically outperformed small during 'Downturn' regimes, and have more frequently led small following the start of Fed cuts," said BofA.