Ominous economic sign for small U.S. firms amid banking sector woes

A rally in U.S. stocks is leaving smaller companies in a tailspin, a sign that investors may be anticipating economic turmoil.

The small-cap Russell 2000 is down about 1 percent this year, compared with a rally that sent the S&P 500, an index representing the largest U.S. companies, up 7 percent.

An inverted U.S. Treasury yield curve and strength in gold prices, along with weakness in the stocks of smaller companies — which are internally profitable and more vulnerable to economic changes than larger companies — are among several signs investors are worried. Economic perspective.

Small-cap stocks have struggled since turmoil at U.S. regional banks began in early March, with the Russell 2000 down 7 percent since March 8. Investors fear that smaller companies will be hit hardest by a potential credit crunch affecting the broader economy.

Investors are „trying to position their portfolios for what they think is going to happen in the economy,” said Eric Kuby, chief investment officer at North Star Investment Management, which specializes in small caps.

„The fact that small caps are out of favor is another signal that investors are bracing themselves for an impending slowdown.”

Small caps have floundered in the past in the face of economic weakness. Since 1980, the Russell 2000 has underperformed the S&P 500 by an average of four percentage points during the six months leading up to a recession, when the economic cycle peaks, according to Strategas data.

Although inflation and some other key metrics have cooled, economic data so far have shown few signs of a sharp slowdown in growth. However, some market participants believe the central bank’s 500 basis point rate hike over the past year is starting to hurt the economy.

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„We’re going to see a recession in the next 12 months,” said Michael Aron, chief investment strategist at State Street Global Advisors. „Typically in a recession, small caps underperform.”

At the same time, investors worry that bank instability could hurt small U.S. companies that rely on loans from regional banks, which have been at the center of the recent crisis.

An April survey by the National Federation of Independent Businesses found that 67 percent of small business owners use a small or regional bank, 17 percent use a medium-sized bank, and 14 percent use a large bank.

Small bank stocks have been hit hard in recent weeks, while funds are also heavily represented in indexes that track small-cap stocks, accounting for some of the weakness relative to the S&P 500.

„What’s happening in the banking system is a headwind, especially for small and mid-sized companies,” said Sameer Samana, senior global market strategist at Wells Fargo Investment Institute.

Last month it downgraded its outlook on US small caps to „strongly unfavorable” from „unfavorable”.

„For them to borrow, they don’t have the same kind of options that a big company would have,” Mr Samana said.

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Next week investors will focus on economic data, including monthly retail sales and earnings reports from companies including Walmart, Home Depot and Cisco Systems.

Some investors are very bullish about the outlook for small caps, especially when looking beyond the next few months.

One reason is that small caps, which are sensitive to economic fluctuations, tend to shine early in market recoveries.

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Over the past six bear markets, the Russell 2000 has averaged a 44.8 percent gain in the six months following a bear market bottom, compared with a 32.2 percent gain for the S&P 500, according to brokerage Edward Jones.

Quotation

A lot of investors are now nervous about leaning into small caps

Tim Murray, d. Capital Markets Strategist at Rowe Price

The S&P 500’s rally this year has come despite an uncertain earnings outlook, and small-caps are also cheap relative to their historical counterparts as investors worry that large-cap stocks are too expensive.

The small-cap S&P 600 trades at a price-to-earnings ratio of more than 13 times, compared with its 10-year average of 18.2 times, according to Refinitiv Datastream.

D. Tim Murray, capital markets strategist for the multi-asset group at Rowe Price, said the firm is overweight US small-caps in its multi-asset portfolios, noting that they have already taken „a lot of pain” amid widespread recession concerns.

„A lot of investors will be nervous right now about leaning into small caps,” he said.

But “the upside you get in small caps is usually very front-loaded and [comes very quickly after] A recession is priced in”.

Updated: May 13, 2023, 12:24 pm

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