The Perplexing Rebound of Small Caps

Can the sudden rise of the Russell 2000 continue in the wake of mounting negative economic indicators?

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John Kinsellagh
May 14, 2020
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How can one explain the small-cap sector’s remarkable rise after its near-death experience in late March? Consider the early March backdrop, against which the recent surge in the Russell 2000 should be evaluated.

Back in late March, the S&P 500 was down 28% from its Feb. 19 record high, while the Russell 2000 small-cap index dropped more than 35% over the same period and still remained far from its high reached in August 2018 .

It should be noted that even with the market’s post-March recovery, the Russell 2000 is still down 20%, while the S&P 500 is now only 9.3% off its most recent pre-coronavirus high. In light of the recent dismal standing of the small-cap index, what is responsible for its incongruous resuscitation?

There are several factors that explain the turnaround.

One is the action of the Federal Reserve, whose stimulus and market-stabilizing responses were swift, massive and unprecedented in their scope. Many investors feel the anticipated bad news that lies around the corner for the second quarter is already priced in the current Russell 2000 level. Current expectations are in no small part guided by investors' belief that the breadth of the stimulus will ease any late 2020 economic pain and pave the way for a favorable recovery, which many believe will inure more favorably to the benefit of the small-cap sector.

A review of the movement in both the iShares Russell 2000 Exchange-Traded Fund (IWM) and the S&P Small Cap 600 last week buttresses this contention.

The Russell ETF was up 3.3%, which was its strongest weekly gain in over a month. The S&P Small Cap 600 was up 3.2%. By comparison, during the same period, the S&P 500 gained only 1.4%. Over the past month, while the S&P 500 has increased 6.3%, the Russell 2000, albeit at times erratically, has surged approximately 11% higher.

The most fundamental question presently, in terms of small-cap risk, is will the recovery follow a path more akin to the projections of those investors favorably disposed toward the depressed small-cap sector? Or will the actual economic post-Covid-19 fallout be far worse than anticipated by bullish, and perhaps even bearish, investors?

There are some skeptics who question whether now is truly a propitious time to increase positions in smaller companies.

Some of the concerns expressed by analysts who don’t share investor exuberance over the present favorable valuations of the Russell 2000 are identical to those warnings concerning the direction of the large-cap sector. Namely, the overall market is mispricing the extent, duration and severity of the coronavirus-induced economic downturn.

Many analysts have argued that the current level of the S&P 500 — off only 9.3% from its high — does not adequately reflect the actual severity of unemployment as well as the likely dismal second and third-quarter growth rates. The paths of the economy and the stock market are starkly diverging.

There are a plethora of adverse economic factors that could prove much worse than expectations or a recovery currently held by many investors: there could be a second wave of infections that could result in another nationwide lockdown and hit to earnings; the unemployment rate could exceed current forecasts; recent job displacements could become permanent instead of temporary; and, even if the virus is gradually contained, many may not feel sufficiently secure to return to their workplace environments.

Here, the danger for the small-cap sector is even more pronounced than for that of larger capitalized companies. Any worsening economic environment that proves more detrimental than initially forecast would impact smaller companies disproportionately: larger companies, because of their sheer size, have a slightly greater cash resources to cushion any further economic jolts. Many smaller companies don’t have cash flow positions that can be sustained on a long or intermediate-term basis.

Another risk? Although many small-cap stocks indeed do appear to be undervalued, it should be noted that many of these companies had weaker earnings and higher levels of outstanding debt than larger capitalized firms, even before the pandemic. Many of the small caps have thrived over the past decade in favorable economic headwinds that saw unprecedented continuous consumer confidence and spending that helped contribute to the favorable and unbroken earnings growth rates of small businesses. Yet, the converse is also true. The small cap-economic recovery expectations game is a double-edged sword. Many of the same businesses that thrived during the bull market, such as restaurants and entertainment venues, stand to be hit the hardest should the coronavirus outbreak remain unchanged.

Any one of the unfavorable conditions noted above, could have a profound and deleterious impact on the small-cap sector.

The watchword for intelligent investors? Make certain your bargain candidates have strong balance sheets that are sufficient to withstand what may turn out to be a more dire economic contraction than many optimists had confidently projected.

Disclosure: I have no positions in any of the securities referenced in this article.

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