Wells Fargo Sees Near-Term Upside for Small Caps Amid Political and Economic Uncertainty

Wells Fargo analysts believe current market conditions offer a compelling opportunity for short-term gains in small-cap stocks, given the close U.S. presidential race and certain economic catalysts. The investment bank suggests that the "50/50" nature of the race, particularly with the potential for a Trump victory, could result in favorable returns for small caps.

"Small caps have a positive expected near-term relative return as the presidential race is essentially a coin toss (per RCP) with five weeks to go," the analysts wrote. "Expected small-cap returns are favorably skewed, with significant near-term outperformance in the event of a Trump win and limited underperformance with a Harris victory."

Potential Outperformance with Trump Win

If Trump is re-elected, Wells Fargo anticipates a 5-10% outperformance in small caps within one to three months. This prediction is based on market behavior following the 2016 election and the reaction to an assassination attempt on Trump in July 2024. In 2016, the S&P 600 Small Cap index rose 15.7% by year-end, in contrast to a 5% gain in the S&P 500. After the July 2024 incident, the S&P 600 increased by 6.4% by the end of the month, while the S&P 500 dropped by 1.6%.

Limited Downside for Harris Win

Even in a scenario where Vice President Kamala Harris wins the presidency, Wells Fargo projects only limited downside for small caps, with an estimated 2-3% underperformance. The report does, however, emphasize that Harris’s policies are less clearly defined, making it challenging to forecast their exact impact on the market.

Broader Economic Factors

Wells Fargo also highlights other macroeconomic factors, such as the Atlanta Federal Reserve’s projected 3.1% GDP growth for Q3, which exceeds consensus estimates. Historically, instances where GDP growth outperforms expectations have led to significant gains for small-cap stocks. The GDP report, scheduled for release on October 30, is seen as a potential catalyst for the small-cap segment.

Market Positioning and Strategy

Wells Fargo recommends that investors add small-cap exposure in anticipation of these positive factors.

“Time for a tactical shift to smaller caps and select cyclicals related to relative performance, expected returns around the election, and a possible GDP catalyst,” the analysts continued.

Long-Term Investment View

Despite the near-term optimism for small caps, Wells Fargo maintains a preference for mid-cap growth stocks over the long term, citing a favorable risk-reward profile.