Bargain hunters have piled back into US small-cap stocks, taking advantage of their cheapest relative valuation to their large-cap peers in a decade and a half, as concerns about a recession ease.
In the week ended September 6, investors poured $1.5bn into the biggest exchange traded fund tracking companies with a smaller market capitalisation, the iShares Russell 2000 ETF, for its largest weekly inflow in almost a year.
That followed a $340m inflow in the final days of August, which put an end to four consecutive weeks of net withdrawals — the longest streak of outflows since early 2018.
The rebound comes amid a broader rotation into cheaper equities and away from “defensives” and bond-proxy stocks that built up momentum over a tumultuous summer.
Over the past few months, nervous investors had dumped riskier assets and sought havens such as US Treasuries. This pushed yields on the latter to record lows in August and prompted one indicator of an impending recession to flash its strongest signal since the financial crisis, as the 2-year bond yield exceeded its 10-year equivalent.
The market unease drove the valuation of the Russell 2000 to its lowest relative to large-cap equities since June 2003, according to Jefferies. The investment bank forecast that small-cap stocks would outperform their larger cousins by 6 percentage points over the next year, following a 14 percentage point underperformance over the past 12 months.
“They’re down on their butts,” said Steven DeSanctis, equity strategist at Jefferies. “But you get a bit of positive reprieve around growth globally and no recession for the US, and [small-caps] are going to do well.”
Repeated headlines about the US-China trade war have contributed to volatility over the summer, as has confusion over the Federal Reserve’s outlook for interest rates.
“We wouldn’t want to be fighting a Fed that is looking to be more accommodative over the coming quarters and into an election year,” said Chris Retzler, manager of the small-cap growth fund at Needham Asset Management.
Lower interest rates have historically been supportive of small-cap equities. Over the past six decades they have risen an average of 28 per cent in the first 12 months after the start of a Fed rate cut cycle, compared with 15 per cent for large-caps, according to Jefferies.
The Fed’s rate cut in July, its first since the financial crisis, and a recent steepening of the yield curve rekindled bullish spirits and has pushed the S&P 500 to within 2 per cent of a record high. Whether it will also be enough to drive the Russell 2000 past its peak of August 2018 remains to be seen. The index is down about 11 per cent from that mark.
Craig Stone, small-cap portfolio manager at Kayne Anderson Rudnick, said that after a fairly narrow market rally over the past 12 to 18 months, there needs to be a broadening-out of gains for indices to continue their record run. “I think it’s a possibility but, at the end of the day, earnings growth drives returns and we do have to have a better economy for that to happen.”
Profits for small-cap companies are expected to contract 3.5 per cent this year, compared with a 1 per cent rise for large-caps, according to Jefferies figures. In theory, that has already been factored into prices, so if companies’ profit downgrades in the upcoming earnings season are less dire than Wall Street forecasts, small-cap stocks could still move higher.
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