Traders work on the floor of at the closing bell of the Dow Industrial Average at the New York Stock Exchange on October 31, 2018 in New York.
Bryan R. Smith | AFP | Getty Images
The performance gap between small caps and large caps is widening to historic lows, a trend seen during times of economic stress and investor caution, possibly signaling something worse with the economy could be coming.
The small-cap benchmark Russell 2000 is in correction territory, trading nearly 14% below its 52-week intraday high in August 2018. Tthe S&P 500 is only off by 4% from its high. Something doesn’t add up.
“Large cap outperformance of small caps is reaching historic levels, and is noticeably a function of global investor caution,” Raymond James’ Tavis McCourt said in a note to clients. “This is a classic liquidity premium, and is noticeable in all recent periods of global economic fear.”
When small and mid-cap stocks start underperforming large stocks at this magnitude, it usually means investors are worried, so they are huddling in big names that are easy to trade and shedding smaller companies generally considered riskier, especially if they believe there’s a recession ahead.
“The Russell 2000 is probably a better measure of U.S. investor psychology,” said McCourt.
This occurred during past soft patches since the financial crisis. Ultimately, this has been resolved with risk appetite increasing and investors going back into smaller stocks. Small-cap stock performance relative to large-caps is now near its lowest level since the financial crisis, so if smaller stocks don’t bounce back, it could signal a bigger crisis than those that have occurred the last 10 years.
Earlier this year, small caps had been having the best start to a year since 1987. However, the confluence of the U.S. China trade war and global interest rates at all-time lows spurred investor worry about the global economy, sending small caps to fresh lows.
“Smaller stocks and value stocks tend to work when you start to see a recovery in the profits backdrop,” said Jill Carey Hall, Bank of American Merrill Lynch U.S. equity strategist. “The valuation looks compelling but a lot of the data hasn’t turned yet.”
The ‘safe-from-China’ fallacy
The common belief for investors is that since small-cap companies are more domestically facing, with less exposure to China, the group should be less exposed to trade wars and tariff fights. This theory would mean small caps were outperforming as trade headlines dominate the markets.
Small- and mid-cap strategist at Jefferies Steven DeSanctis calls this untrue, because small caps are often suppliers to large-cap companies.
“Its a little bit of a fallacy because small-cap companies are suppliers to large-cap companies,” said DeSanctis.
“That gap between how much foreign sales small caps have versus large caps has been narrowing in recent years,” said Hall.
Hall said the idea that small caps are more insulated from the trade war is a misconception, and that a backdrop of escalating trade conflict and rising geopolitical risk tends to be the times when small caps underperform the most.
“Small-cap leverage ratios are at record highs, both relative to their own history and extreme relative to large caps,” she added.
Investors also favor large caps in time of economic uncertainty because small caps have more relative debt on their balance sheets. Small caps are stretched on debt to capital and net debt EBITA. The gap is at some of its highest levels, the only exception being the dot-com bubble.
Companies that can’t refinance their debt are left with a real overhang and a higher risk of default, said DeSanctis.
“Investors are saying we are very late in the economic cycle, you really want to be careful about companies that have leverage. They want cleaner balance-sheet stories,” said DeSanctis.
What about earnings?
Large caps are delivering much better earnings growth than small caps this year.
Small-cap earnings growth was down 14.4% in the first quarter and is on track to be down 13.5% in the second quarter, according to FactSet. Negative growth in two consecutive quarters means the group of stocks is in an earnings recession.
“I do think you have some margin compression in small caps where margins can’t handle additional costs, whether that’s gong to be higher wages, obviously now it’s tariffs,” said DeSanctis.
Despite small caps being much cheaper than large caps, the small caps are still giving downward earnings revisions, said Hall.
Hall also noted about 25% of the Russell 2000 stocks are nonearners, meaning a quarter of the index does not turn a profit. She said you typically don’t see that level unless you’re in a recession or heading into one.