U.S. stocks lost ground for five straight days last week, but the pain dealt to the major benchmarks was nothing compared with those felt by small-cap stocks.
While the S&P 500 index
and the Dow Jones Industrial Average
both lost 2.2%, the small-cap tracking Russell 2000
fell by 4.3%, according to Dow Jones Market Data, and this sharp downside divergence between small and large cap performance could spell trouble ahead for the broader market, according to some analysts and investors.
“Small-caps are very sensitive to where the economy might be going,” said Dave Lafferty chief market strategist at Natixis Investment Management, in an interview, adding that the “beta-driven market,” or one in which stocks move in tandem based on macroeconomic news rather than company-specific information, has hit the smaller, less-proven companies on the Russell 2000 more than their larger cousins, of late.
“What you had in recent weeks is a bunch of bearish news and weak-to-average data points,” like Friday’s jobs miss as well as reports showing a slowing manufacturing sector and weaker growth abroad, “that has caused the market to pull back, starting with small-caps,” he said.
Michael Kramer, chief executive officer of Mott Capital Management, told MarketWatch that he has paid special attention to the Russell 2000 index of late, following the late-2018 stock market swoon that was preceded by a steep pullback in small-cap stocks. “The Russell encompasses so many different sectors and names that when I saw the divergence between it and the S&P, I became concerned that we would see a repeat of last fall,” he said.
To be sure, the Russell is not always the best leading indicator for the S&P 500. According to a recent analysis by Ned Davis Research, the Russell 2000 index has more often that not hit its peak after the S&P 500 reaches a new high. The Russell 2000 is made up of the bottom 2,000 stocks by market cap in the Russell 3000 index.
But Steven DeSanctis, small-and-mid-cap equity strategist at Jefferies, argued in an interview that when macroeconomic concerns are the major driver of stock prices, it makes sense to continue to expect small-cap stocks to act as a leading indicator.
“Small cap [companies] are a reflection of the U.S. economy, and when investors came back from last summer break, and realized that the economy was really slowing,” they sold their small cap holdings first. The Russell 2000 hit an all-time high on Aug. 31 of last year, followed by the S&P 500’s all-time high on Oct. 3rd. From those highs to Dec. 24, the Russell fell 27.1%, while the S&P 500 fell 19.6%.
Since those Christmas Eve lows, the S&P has gained 17.2%, while the Russell has rallied 25.3%.
It was a mistake to assume, DeSanctis said, that small-cap stocks would be more immune to the effects of the U.S.’ trade disputes with China and other market, just because smaller companies tend to have a more domestic-focused market.
“A lot of these companies are suppliers to bigger firms like Boeing
or General Motors
that do sell abroad,” he noted, adding that smaller companies are also less able to adjust their supply chains to blunt the effects of rising input prices that result from higher tariffs.
In other words, small-cap stocks are nearly as susceptible as large-caps to volatile market sentiment related to trade concerns. Furthermore, they are typically less diversified businesses with often heavier debt burdens that, according to BlackRock’s Richard Turnill “leaves them less resilient during periods of decelerating growth and rising uncertainty, like the one we see ahead in 2019 as the U.S. economy enters a late-cycle phase.”
One bright spot for the asset class are earnings projections: while DeSanctis sees Russell 2000 companies posting declines in earnings in the first quarter, he predicts that full year 2019, small cap earnings growth will outpace large, growing by 6% to large cap’s 3%. “When the market goes risk on,” DeSanctis said, “you’ll see it in small cap names before the larger companies.”