Investors’ enthusiasm, warranted or not, was demonstrated with advances in the major market indexes in the 2% range for the past week. For the benchmark
S&P 500,
its 2.24% gain capped a 9.63% three-week surge, the best showing over such a stretch going back to the week ended June 5, 2020.
Perhaps nowhere was the outburst of enthusiasm more in evidence than in smaller-capitalization stocks. It seems as if these diminutive names have been out of favor for, I don’t know, forever.
That impression might be distorted from my personal baptism of fire from leaning heavily (for me, at least) into a small-cap fund back in 1987. I was sold on the notion that the small fry were less risky for having lagged behind the biggies that had powered major indexes to then-giddy heights. I don’t recall if I fared better or worse than the 22% bloodletting in the
Dow Jones Industrial Average
on Black Monday, Oct. 19, of that year, but it taught a tough lesson that there are few places to hide from the bear.
Once again, the small fry have lagged behind for a long time. It has been over 500 days since the
Russell 2000,
the small-cap benchmark, made a new high, according to a client note from Strategas’ Nicholas Bohnsack. That was back on Nov. 8, 2021, and almost 26% higher than Friday’s close, after a hefty 5.4% increase for the week.
Before that, a rally across stock and bond sectors in the wake of a better-than-expected consumer price index report this past Tuesday lifted the Russell 2000 into positive territory for the quarter and the year, Nicholas Colas, co-founder of DataTrek Research, wrote in a Thursday missive. Even so, he added, small-caps still badly trailed the S&P 500, the big-stock benchmark. As of the preceding session’s close, the Russell 2000 was up 2.3% in price from the beginning of the year, eating the dust of the S&P’s 17.3% advance to that point.
The laggard performance of small-caps made them relatively cheap, however. The forward price/earnings ratio for the Russell 2000 fell to a 14-month low, Bank of America strategists Jill Carey Hall and Nicolas Woods wrote in a Nov. 13 research note. The Russell 2000 trades at 12.3 times forward earnings estimates, 19% below its long-term average, and 12.6 times trailing earnings, they noted.
What’s remarkable about the latter metric is that so many smaller stocks don’t have any E, which would arithmetically raise the P/E ratio. Some 40% of Russell 2000 companies are unprofitable, Torsten Sløk, the chief economist at Apollo Global Management, pointed out in a note on Friday.
Such a high percentage of smaller companies operating in the red wouldn’t be surprising in a recession. But the economy is barreling along, with profits expanding. “The bottom line is that if the economy enters a recession, a lot of middle-market companies will be vulnerable to the combination of high [interest] rates and slowing growth,” he concludes.
None of which seemed to impede the powerful rally in the Russell 2000 this past week. Indeed, Tuesday’s pop was the strongest since 2011, Strategas’ Bohnsack noted. While he called that performance “enticing,” he nonetheless warned about the prevalence of money-losing smaller-cap companies in that index.
“While we do not discount the potential for an AI-powered, small-cap-led ‘Tech Boom 2.0’ to feature prominently in the next bull cycle, the current crop of small-cap shares (both public and private) needs to be cleared of dead money in general and of erstwhile growth darlings in particular. Higher interest rates will continue to put a stitch in the side of small-cap earnings and franchises with fettered access to the capital markets,” Bohnsack wrote.
Once again, the sudden enthusiasm for small-cap stocks appears to be a kind of circular thinking. These riskier, less-well capitalized shares would benefit from an easing in Federal Reserve monetary policy. But that would come in response to an economic downturn, further hurting earnings, which don’t exist for a swath of these companies even in the current expansion.
Despite small stocks’ recent pop and persistent cheapness, James Reilly, markets economist at Capital Economics, advises investors to stick with market-cap-weighted U.S. growth indexes dominated by those Magnificent Seven megacap names. They will be less exposed than small-caps “to the combination of high interest rates and weak growth that we’re expecting,” he writes in a research report. Investors ought to temper their enthusiasm in small-caps in particular.
Write to Randall W. Forsyth at [email protected]
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