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Small capitalization stocks have not done as well as large cap stocks in the rebound from the March 23 lows in the U.S. benchmark equity indexes, offering a warning sign to equity investors, analysts say.
During the week ending Tuesday, the Dow Jones Industrial Average DJIA, -4.28% gained 6.6% and the S&P 500 index SPX, -4.48% added 6%, but the Russell 2000 RUT, -6.57% , which tracks small-cap companies gained just 4.3% and the S&P Small Cap 600 SML, -7.00% advanced only 4%.
Meanwhile, small-cap indices suffered more severely in the coronavirus-related selloff this month than their large-cap peers. During March, the S&P 500 fell about 12%, while the Russell 2000 fell nearly 23%.
Analysts at Bespoke Investment Group wrote that the underperformance of small-cap stocks can be attributed in part to the nature of recently enacted fiscal and monetary stimulus which has helped power recent gains. “So far, relief measures passed by Congress and introduced by the Fed are either focused on the investment grade market, small business, or attach pretty significant strings to government support,” they wrote in a Monday evening note to clients.
Small-cap stocks are often not small businesses, which the government typically defines as those with fewer than 500 employees, and so they can’t access funds earmarked for those firms, nor do they typically have investment-grade credit ratings to issue the kind of debt the Federal Reserve has been buying to stabilize markets.
Companies within the Russell 2000 vary greatly in size, with market capitalizations of its constituents ranging from $152 million to $5 billion, with the median company worth about $817 million, according to FTSE Russell. The Small Business Administration also has asset-based size standards for defining a small business that vary by industry, with the vast majority of companies designated as a small business owning fewer than $30 million in assets.
Given that small-cap underperformance dates back before the economic stimulus package approved by Congress last Friday lagging returns of small caps could also indicate investor sentiment toward the broader economy, and thus present a red flag to investors in large firms.
Philip Lawlor, managing director of global markets research at FTSE Russell told MarketWatch that there are several factors leading to the underperformance of the Russell 2000 relative to the Russell 1000 RUI, -4.36%, which tracks the roughly 1,000 largest publicly traded companies, including the fact the small-cap index is dominated by companies in cyclical industries like banks, which tend to underperform during market downturns.
“There’s an awareness that what we’re facing is an unprecedented economic paralysis that we’ve not experienced since the Second World War,” Lawlor said. “This is all feeding into risk aversion,” that will benefit larger companies with lower debt levels in defensive areas of the market, he added.
“When you have small caps lagging the large caps, and you have leadership out of the defensive areas, both of those are consistent indicators that we’re in a bear market environment, not that we’ve gotten through something,” Willie Delwiche, investment strategist at Baird, told MarketWatch.
The best performing sectors in the month of March have been consumer staples and health care, followed by technology and utilities, with all but tech stocks considered defensive in nature, or those that perform better during bear markets.
Lawlor said that the unprecedented nature of the current economic slowdown, wherein whole sectors of the economy in much of the U.S. have been forced to grind to a halt, will produce an “eye-watering” hit to corporate profits that the market has yet to appreciate.
“That’s why investors aren’t looking for heroes in the small cap universe or trying to be clever by cherry picking,” he said. Cuts in earnings forecasts “have yet to hit the market and we will know where the valuation flaws are in the market when we see the whites of the yes of the analyst downgrade cycle that’s about to hit us.”
See also: The Fed’s ‘Main Street’ lending program is aimed at companies in the middle, Daly says
