Worried About World Economy? Bet on US Small Caps: Goldman

Wall street bull
Adam Jeffery | CNBC

Small cap equities should sharply outperform their large cap counterparts over the next year, if domestic growth continues to outperform the global economy, according to Goldman Sachs.

Goldman Sachs analysts expects the Russell 2000 small-cap index to generate a total return of 14 percent over the next 12 months compared to a modest 6 percent for the S&P 500 index.

"Small cap equities are well-positioned if domestic growth accelerates and investors preference for domestic cyclical exposure continues," the analysts said in a report. "We forecast Russell 2000 earnings per share will grow 22 percent in 2013 and a further 23 percent in 2014. If realized, those growth rates would be more than twice our S&P 500 forecasts of 11 percent and 8 percent, respectively."

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Small caps traditionally have less international exposure than larger companies and are more sensitive to growth in general. The Russell 2000 generates less than 20 percent of sales outside of the U.S., while the S&P 500 companies collectively make nearly a third of its revenue from international markets. And cyclicals with non-U.S. revenues have lagged the market in 2013, gaining just 5 percent versus 15 percent for domestic cyclicals and 17 percent for defensives.

"The domestic/international performance split reflects confidence in the U.S. economic outlook for the second half of 2013 but also the ongoing recession in Europe and recently reduced growth expectations in China," according to Goldman Sachs.

A recent bout of negative data from China and Europe has raised further red flags in the market.

Most recently, China's economic growth unexpectedly slowed in the first quarter to an annual rate of 7.7 percent from the 7.9 percent pace set in the fourth quarter of last year. Adding to woes, the World Bank last week pared back its 2013 growth forecasts for developing East Asia.

At the same time, confidence in the euro zone's economy has declined by more than expected for a second month in April, further underscoring the region's challenging road out of recession.

Meanwhile, U.S. data has hit what is seen as a temporary soft patch, but housing has remained encouraging and jobless claims data have returned to a lower pace. U.S. first quarter GDP grew at a disappointing 2.5 percent rate in the first quarter, and economists expect it to be about half that in the second quarter, before recovering later in the year.

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—By CNBC's JeeYeon Park (Follow JeeYeon on Twitter: @JeeYeonParkCNBC)

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