Small-cap stocks, once the darlings of the post-election rally, are facing yet another challenging year with the Russell 2000 index (^RUT) hitting its lowest level on Wednesday, since November 6, 2020, just a day before President Biden’s election was called by most media outlets. This decline marks a significant setback for small-cap investors, signaling the end of an era where they outpaced their larger counterparts.
The small-cap resurgence was nothing short of remarkable in the aftermath of the 2020 election. Within four months, small caps soared by 45%, leaving the Dow, Nasdaq, and S&P 500 trailing behind with roughly half that performance. However, the glory days of small-cap trading seem to be a distant memory.
Year-to-date, the Russell 2000 is down 6%, while the Nasdaq still boasts a substantial 22% gain, and the S&P 500 is up 9%, aligning closely with its historical average annual return. The promising economic recovery, driven by President Biden’s $1.9 trillion fiscal stimulus package early in his tenure, initially heightened optimism for small-cap companies, which were expected to reap the benefits of increased domestic spending. Data from JPMorgan Asset Management revealed that a substantial 22% of Russell 2000 members’ revenue came from overseas, whereas the S&P 500 relied on international markets for approximately 40% of its revenue.
Unfortunately for small-cap firms, the narrative changed as the interest rate tightening cycle unfolded, raising capital costs and penalizing companies with smaller market capitalizations that tend to have more volatile balance sheets and financing needs than their larger counterparts. The same JPMorgan study noted that, by the end of 2021, a staggering 40% of Russell 2000 companies were not profitable.
Bank of America’s equity strategy team issued a warning, asserting that “The real risk is in the Russell 2000” due to the increased debt rollover needs of these companies compared to S&P 500 firms. The sentiment among investors now aligns with this cautionary note, as they seem to be turning their backs on small caps.
The significant challenge for those hoping for a small-cap resurgence is that historical market trends indicate that the next driver of small-cap outperformance may be a factor that the US economy is currently postponing – a recession. In a recent analysis, SoFi’s head of investment strategy, Liz Young, pointed out that small-cap stocks typically outperform when the unemployment rate rises. This may seem like an unusual correlation, but there are logical reasons behind it.
Job losses often accelerate in the late stages of the business cycle, and unemployment tends to spike before the National Bureau of Economic Research (NBER) officially declares a recession. When the jobless claims increase and the dreaded “r-word” resurfaces, investors may reconsider small caps.
Historically, once the economic storm clouds dissipate and the markets stabilize, small caps typically lead market returns, surpassing their larger counterparts. Morningstar Direct data reveals that six months after a recession ends, small cap typically experience a total return of over 30%, nearly double the 16.9% return seen in large caps over the same period. Following the brief pandemic-induced recession in 2020, the Russell 2000 surged by 17.4% over the next six months, while the S&P 500 registered a more modest 12.3% gain.
Despite the Federal Reserve implementing its most significant tightening measures in over four decades, the US labor market has shown remarkable resilience. This resilience explains why small caps failed to lead the current bull market in large caps last year, and why this once-hot pandemic-era trade continues to face challenges in finding its footing in the current market landscape.
In conclusion, the struggle faced by small-cap stocks, as exemplified by the Russell 2000, serves as a barometer of the complex dynamics at play in the ever-evolving financial landscape.
Source: Yahoo Finance
