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John Kinsellagh
John Kinsellagh
Articles (115) 

Small-Cap Surge Grinds to a Halt

Sector slows due to economic uncertainty, continually rising rates and valuations that now appear overly generous

December 14, 2018 | About:

Since late 2016, the small-cap sector has soared on an unbroken upwards trajectory, as the Russell 2000 index surged past the S&P 500. For most of 2018, small-stocks delivered enviable double-digit returns. While the S&P 500 rose 8.5% in the first eight months of this year, the Russell 2000 posted a 13.4% return.

Many individual small-cap funds realized spectacular returns; some small-cap growth fund managers' trailing 12-month returns exceeded 50%.

However, the superior performance of the smaller-cap sector relative to S&P 500 companies has unceremoniously halted. Both the small and large cap sectors have fallen prey to the impact of uncertainty about continuing economic growth as well as the likely direction of the yield curve. The impact on the small cap sector, however, has been disproportionately greater, as smaller companies are more sensitive to increased borrowing costs and rising wages.

The small cap sector’s fall has been pronounced. After its 16% drop from its all-time high reached on Aug. 31, the Russell 2000 index is now the only one of the major benchmarks to be close to hitting bear market territory. The S&P 500, by comparison, is off 10% from its September record, while the Dow Jones Industrial Average has descended 9% from its October high.

At the time when incipient trade tensions between China and the U.S. remained in the bluster stage, many investors, concerned about the likelihood of the dispute escalating into an actual tariff duel, flocked to small caps as a shelter from the commercial storm.

Larger caps had greater trade-related exposure, as they earned a larger percentage of their revenue from overseas operations. Small caps, by comparison, were to some extent protected, as most revenue generated was from their domestic operations. Small caps particularly benefited from the tax cuts enacted in late 2016 disproportionately, just as profits at their larger peers rose dramatically.

For the past two years, despite small rate increases from the Fed, the small-cap sector surge occurred in an environment of relatively low interest rates, which clearly was advantageous for smaller firms, as the leverage from borrowed funds permitted many smaller companies to generate outsized returns in the booming economy.

Although small caps of predominantly domestic-based businesses insulated them from the deleterious effects from the trade wars, they are not immune from the uncertainty concerning the direction of the economy and the likely trajectory of interest rates. A significant reason for the recent market volatility and concomitant drop in the major indexes is due to the tremendous uncertainty about whether the economy is continuing to expand or is on the cusp of contracting.

There have been mixed signals in this regard, and large caps and the small companies are subject to the same uncertainties. Just as a surging economy, lifting burdensome regulations and benefits of the tax cut all disproportionately inured to the advantage of smaller firms, the converse is also true. The tremendous economic uncertainty that currently prevails is having a profound effect on the small-cap corporations. Their sustained profit growth has relied on the booming economy and strong consumer spending.

Small caps are substantially more leveraged than their larger cap counterparts. According to Lindsey Bell, an investment strategist at CFRA Research, the debt load of Russell 2000 companies is approximately double that of corporations in the S&P 500. The small cap index’s level of corporate debt is almost 3.3 times Ebitda versus 1.3 for the S&P 500. That is a notable difference — particularly in an environment where borrowing costs are sure to increase.

Another reason for the pause in the small cap group is that in 2019, the rising tide occasioned by the 2017 tax cuts will have subsided considerably, and expectations for profit growth are now more subdued.

Last, many investors flocked to small caps at the first sign of potential commercial conflict with China. Any likely impact from trade-related issues on the small cap sector were minimized or ignored entirely. As the Russell 2000 began its meteoric rise from early 2017 through late August 2018, the small cap play evolved into a crowded trade, pushing up valuations to a level that now, given all the economic uncertainty, appears rather generous, especially compared to the S&P 500.

The decline of the Russell 2000 has been so precipitous that even though uncertainties about the direction of the economy impact the sector, many individual companies have been dragged down by the overall small cap market that they currently could present good opportunities for value investors.

I have no position in any of the securities referenced.

About the author:

John Kinsellagh
John Kinsellagh is a freelance writer, former financial advisor and attorney specializing in civil litigation and securities law. He completed the Boston Security Analysts’ Society course on "Investment Analysis and Portfolio Management."
He has served as an arbitrator for FINRA for over 25 years resolving disputes within the financial services industry. He writes primarily on financial markets, legal and regulatory issues that impact the investment community and personal finance.
He is the author of "The Mainstream Media-Democratic Party-Complex" and "Election 2016", both available on Amazon. Follow him on Twitter @jkinsellagh

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