US Small Caps As Catch-Up Trade

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US Small Caps As Catch-Up Trade

We’ll re-ask a question we first posed to you a few weeks ago: what are the odds that the US stock market has seriously flubbed its biggest, most important call since World War II by rallying so hard off the March lows? At the time we said that we thought the probability of that sort of epic screw-up were pretty low. With the S&P topping 3,000 intraday today it’s hard to feel any different now. Regardless of how we got here, US large cap stocks are clearly saying:

  • Economic recovery will be faster and better than many expectations, including those mentioned in the Markets section.
  • There will be no large second wave of infections that lead to partial/complete shutdowns of important regions or during Holiday 2020.
  • Enhanced unemployment checks won’t just tide American workers; it will actually spur consumption right now and into the second half of 2020. And remember: any halfway solvent public company is in much better position to get through the trough than the vast majority of small businesses.

If one accepts this logic and takes it a step forward, then the question to ask is: “what can I buy for a catch-up trade since the S&P 500’s rally tells me that many lagging stocks/sectors should begin to work better?” The calculus here is trickier than one might think, because:

  • So much of the S&P’s bounce-back is Tech driven. Large cap Technology is +6% on the year and 38% from the March lows. The S&P 500 is still down 7% for the year and 34% off the lows.
  • The S&P 500 Value index is down 17% YTD and only 31% from the March lows.
  • At the same time, some deeper cyclical groups like Industrials, Energy and Financials are trading better of late. The large cap flavor of those three groups is up 6.3%, 4.5% and 6.8% over the last 5 trading sessions respectively, versus 2.4% for the S&P 500.

Historically, US small cap equities are the place to be once economic recovery hits full stride; for example, they outperformed large caps in 2009 (by 70 basis points) and 2010 (by 1,180 bp). But as we saw with the whys and wherefores of the S&P 500’s recent run, the devil is in the details:

#1: The Russell 2000 has no “champion stocks” the way the S&P does:

  • Apple (+8% YTD), Microsoft (+15%), Amazon (+31%), Facebook (+13%) and Google (+6%) are 21% of the S&P 500.
  • The top 5 names in the Russell – Teladoc (+97% YTD), Chegg (+64%), Trex (+43%), Repligen (+44%), and Immunomedics (+62%) – are all doing great but only represent 2.5% of the index.

Bottom line: US small caps as an asset class are much more atomized in terms of single stock exposure than the preeminent measure of large cap performance, so you really need to believe in a US economic recovery to own this group.

#2: The Russell also has quite different sector weights versus the S&P 500:

  • Much more Health Care (+7 points)

    S&P 500: 15.1%
    Russell: 23.2%
  • Much less Tech (-11 points)

    S&P 500: 26.6%
    Russell: 15.4%
  • Much, much more in cyclicals like Financials, Industrials and traditional Consumer Discretionary (+15 points combined)

    S&P 500: 10.6%, 7.7%, and 6.5% (ex-Amazon) respectively
    Russell: 14.8%, 14.4%, and 10.7% respectively

To bring this point home, consider apparel company Deckers (makers of Ugg boots/other brands), Generac (home generators), and United Bank (branches in Virginia, Ohio, Pennsylvania, etc.); those are the sort of names that anchor the small cap overweights in Consumer, Industrial and Financial sectors. Those are the stocks that have to work better than an S&P chock full of Amazon, Apple and Microsoft in order to justify the switch to small caps over large.

#3: Finally, three other issues we always consider when it comes to small caps:

  • On the plus side, high yield bond spreads are still contracting. As mentioned in Markets, these came in by 72 basis points last week and at 706 bp over Treasuries they can still fall further still.

    Here is a 10-year chart of high yield spreads for reference:
  • Good news/bad news: ETF money flows are still negative for small caps. Last week saw $1.1 billion of redemptions, a reversal of the last 3 weeks which had $592 million of inflows. As we described last week, ETFs own about 2x more small cap stocks by shares outstanding relative to large caps.
  • The Russell is slightly less tilted to Growth stocks (62% weight) than the S&P 500 (69%).

Our conclusion: by the weight of this evidence, the Russell should continue to outperform the S&P 500 through at least the rest of Q2 as long as the recovery story holds (and the S&P 500 is signaling that strongly). Over the last month US small caps have closed some of the gap, rising by 13.0% versus 5.5% for the 500, even if it still lags by almost 10 points YTD. The Russell certainly has the sort of cyclical exposure that should help it continue to outperform as long as investor confidence regarding America’s economic restart remains high.