A US stocks rally is leaving behind smaller companies, a sign that investors may be bracing for economic turmoil ahead.
The small-cap Russell 2000 is down about 1 per cent this year, compared to a rally that has boosted the S&P 500, an index representing the largest US companies, by 7 per cent.
Like the inverted US Treasury yield curve and the strength in gold prices, the weakness in shares of smaller companies — which tend to derive profits domestically and be more vulnerable to economic shifts than larger firms — is one of several signs that investors are uneasy about the economic outlook.
Small cap stocks have struggled since turmoil in US regional banks began in early March, with the Russell 2000 down 7 per cent since March 8. Investors fear that smaller firms will be hit hard by a potential lending slowdown that could weigh on the broader economy.
Investors are “trying to position their portfolios for what they think is going to happen in the economy”, said Eric Kuby, chief investment officer at North Star Investment Management, which specialises in small caps.
“Small caps being out of favour is another signal that investors are bracing themselves for an impending recession.”
Small caps have tended to waver ahead of economic weakness in the past. Since 1980, the Russell 2000 has lagged the S&P 500 by an average of about four percentage points in the six months after the economic cycle has peaked, ahead of a recession, according to Strategas data.
Economic data has so far shown few signs of a sharp drop-off in growth, though inflation and some other important metrics have cooled. Still, some market participants believe the Fed's 500 basis points of rate increases over the past year are only starting to impact the economy.
“We are likely headed into a recession sometime in the next 12 months,” said Michael Arone, chief investment strategist at State Street Global Advisers. “Typically in a recession, small caps underperform.”
At the same time, investors worry that banking instability will hurt smaller US companies that rely on loans from regional banks, which have been at the centre of the recent crisis.
An April survey by the National Federation of Independent Businesses found 67 per cent of small business owners use a small or regional bank, 17 per cent use a medium-size bank, while 14 per cent use a large one.
Smaller bank stocks have been hit particularly hard in recent weeks while financials are also more heavily represented in indexes tracking small-cap shares, accounting for some of their weakness in relation to the S&P 500.
“What is going on with the banking system is especially a headwind for small and mid-sized corporations,” said Sameer Samana, senior global market strategist at the Wells Fargo Investment Institute.
Last month it downgraded its view on US small caps from “unfavourable” to “most unfavourable”.
“For their borrowing, they don't have the same kind of options as maybe a larger firm does,” Mr Samana said.
What is a recession?
Investors next week will be focusing on economic data including monthly retail sales and earnings reports from companies including Walmart, Home Depot and Cisco Systems.
Some investors are more upbeat about the outlook for small caps, particularly when looking beyond the next several months.
One reason is that small caps, being sensitive to economic fluctuations, tend to shine early in a market recovery.
Of the past six bear markets, the Russell 2000 has posted an average total return gain of 44.8 per cent in the six months following a bear market bottom, versus a 32.2 per cent gain for the S&P 500, according to brokerage Edward Jones.
Small caps are also cheap relative to their history as investors worry that large-cap stocks have become expensive, with the S&P 500's rally this year defying an uncertain earnings outlook.
The small-cap S&P 600 is trading at a price-to-earnings ratio of just over 13 times, compared to its 10-year average of 18.2 times, according to Refinitiv Datastream.
Tim Murray, capital market strategist for the multi-asset group at T. Rowe Price, said the firm is overweight US small-caps in multi-asset portfolios, noting that they have taken “a lot of pain” already amid widespread recession concerns.
“A lot of investors would be nervous right now about leaning into small caps,” he said.
But “the upside that you get in small caps generally is very front loaded and [comes very quickly after] a recession has been priced in”.
