In a challenging year for small-cap stocks, the Russell 2000 index (^RUT) hit its lowest point since November 6, 2020, just a day before President Biden’s election victory was confirmed by major media outlets. This latest downturn signals a significant setback for one of the hallmark trades of the pandemic era.
Initially, small caps surged post-election, outpacing larger indices with a remarkable 45% rally in a mere four months, while the Dow, Nasdaq, and S&P 500 delivered about half that performance.
However, those robust days are now a distant memory for small-cap investments. Year-to-date, the Russell 2000 has seen a 6% decline, in stark contrast to the Nasdaq’s impressive 22% gain and the S&P 500’s steady 9% increase, aligning closely with its long-term historical average annual return.
Optimism regarding the economic recovery, bolstered by Biden’s $1.9 trillion fiscal stimulus package early in his term, originally fueled the belief that domestically-oriented small-cap companies would be the primary beneficiaries of this lavish spending. Data from JPMorgan Asset Management published earlier this year revealed that 22% of Russell 2000 members’ revenue is generated overseas, in contrast to the S&P 500’s approximately 40%.
Nonetheless, the scenario has evolved with an ongoing interest rate tightening cycle, which has elevated capital costs and weighed heavily on companies with smaller market capitalizations, often characterized by more volatile balance sheets and greater financing needs compared to their larger counterparts. The same JPMorgan study noted that by the end of 2021, a substantial 40% of Russell 2000 companies were operating at a deficit.
As noted by Yahoo Finance’s Josh Schafer, Russell 2000 companies face a greater need to refinance debt in the upcoming years compared to S&P 500 firms. Bank of America’s equity strategy team has consequently underscored the greater risk profile within the Russell 2000.
Presently, investors concur with this assessment. The challenge for those banking on a small-cap resurgence lies in historical market trends, which suggest that the catalyst for outperformance may hinge on an event the US economy has managed to defer—recession.
In a recent analysis, SoFi’s Head of Investment Strategy, Liz Young, highlighted the peculiar but substantiated correlation that sees small caps thriving as the unemployment rate escalates. This correlation stems from fundamental factors tied to late-stage business cycles, where job losses tend to accelerate prior to an “official” recession declaration by the NBER.
Consequently, when jobless claims surge and the “r-word” becomes inescapable, investors may turn to small caps. Post-recession, after the market regains its footing, small caps traditionally lead market returns, as evidenced by data from Morningstar Direct. Six months following a recession’s end, small caps typically exhibit a total return exceeding 30%, nearly double the 16.9% return observed for large caps during the same period.
Despite the most pronounced tightening by the Federal Reserve in over four decades, the US labor market has displayed commendable resilience. This resilience accounts for the fact that small caps failed to lead the charge as the current bull market in large caps took shape last year, elucidating why this once-hot pandemic-era trade continues to face uphill challenges.
In conclusion, the ongoing struggles of small-cap stocks, exemplified by the Russell 2000 index, underscore the shifting dynamics in the market landscape, prompting investors to closely monitor the trajectory of these once-promising assets.
Source: Yahoo Finance
