What’s Wrong With US Small Caps?

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What’s Wrong With US Small Caps?

We are dedicating today’s “Data” section to US small caps because year-to-date returns here are, for lack of a better word, awful. The Russell 2000 is down 11.7 percent so far in 2022. That’s far worse than the S&P 500 (-7.4 pct) or non-US equities (MSCI All-World ex-US Index -7.8 pct). Has the Russell gotten cheap enough to buy?

Three thoughts here:

#1: The Russell has underperformed the S&P 500 over the last year by a statistically unusual amount. Going back 20 years, here’s how US small caps have fared versus large caps:

  • On average, the Russell 2000 has outperformed the S&P 500 by 1.6 percentage points on a 1-year (253 trading days) rolling return basis back to 2002. If the S&P 500 is up 10.0 percent over a year, the Russell will on average be up 11.6 pct.
  • The standard deviation of that performance is 9.9 points, making the 2-sigma range positive 21 percent to negative 18 pct.

This chart shows how the Russell has performed versus the S&P since 2001 on a rolling 1-year price return basis in the context of that 2-standard deviation band of expected relative returns. Relative returns over that period fit comfortably in the 2-sigma range, with four exceptions:

  • The first is Q4 2003 (peak of 30 percentage point Russell outperformance), when US small caps staged a strong comeback from the US equity market lows of late 2002.
  • The second is the March – May 2020 pandemic-related selloff, with the Russell underperforming the S&P 500 by as much as 20 percentage points.
  • The third is the remarkable snapback in small caps in the year after the pandemic lows, with the Russell beating the S&P by as much as 64 percentage points.
  • The fourth is right now, with the Russell lagging the S&P by 19 points over the last 12 months.

Takeaway: yes, US small caps have underperformed large caps over the last year by 2 standard deviations, but that comes hard on the heels of a +5-standard deviation (51 points) upside outperformance the year before. Therefore, we cannot rely just on relative “cheapness” to justify a positive view on the Russell 2000.

#2: US small caps are much more levered to financial conditions, most notably high yield corporate bond spreads over Treasuries, than large caps. That’s because a good third of the Russell 2000 is unprofitable and needs ready access to affordable credit in order to execute on their growth strategies. The S&P 500 is comprised of companies with a proven track record of profitability (a requirement for index inclusion) and these businesses are therefore less reliant on high yield debt markets.

This chart shows high yield spreads back to 2001, the same time frame as the previous graph. The spikes during the Financial Crisis are clearly visible (+15-point spreads), as well as the one during the Pandemic Crisis (10 – 11-point spreads). And, if you line up this chart with the previous one, you’ll find that the Russell outperforms the S&P when high yield spreads are declining (e.g., 2010, 2013, 2016, 2020).

Takeaway: the chart above also shows that at current levels high yield spreads (357 basis points over Treasuries) don’t usually drop much further, and that removes a potential positive catalyst for the Russell here. The best time to buy small caps is when high yield spreads are high, not low.

#3: Three other thoughts on US small caps:

  • The Russell is predominantly a growth stock index. Growth stocks have faced headwinds from higher interest/discount rates for many months now. The Russell 2000 Growth Index is down 16/19 percent over the YTD/last year. Russell 2000 Value is only down 6/3 percent over the YTD/last year. The problem with the Russell is not that it owns “small caps” per se as much as it owns too many small cap growth stocks.
  • The Russell 2000 is unlike the S&P 500 in that it must sell its biggest winners. If a company successfully pursues its vision and its equity value grows dramatically, it will eventually go into the Russell 1000 Large Cap index. The S&P 500 has no such limitation, obviously. In a “winner take most” world, that means the Russell is selling long run winners.
  • In terms of sector and position concentration, the Russell and the S&P are wildly different. The top 5 names in the S&P (AAPL, MSFT, AMZN, TSLA, GOOG(L)) are 23 percent of the index in total. The top 5 names in the Russell (OVV, CAR, CHK, BJ, AR) are 2 percent of the index. Health Care is the largest sector in the Russell (17 percent); Tech is the largest piece of the S&P (27 pct).

Takeaway: while both the S&P and Russell are technically “US equities” in terms of asset class, the differences between them are so large that they require different analytical approaches. The Russell is highly leveraged to changes in economic growth, interest rates, and credit market conditions. The S&P is a bet on the world’s largest companies and their ability to sustain high returns on capital.

Conclusion: we’ve been structurally bearish on US small caps since April 2021, based entirely on their relative return overshoot in Point #1, and we don’t yet see the catalyst for them to outperform. High yield spreads over Treasuries remain low. Interest and discount rates are rising. Investors are looking for safe hiding places to ride out recent volatility; small caps offer fewer options than large caps. On the bright side, once interest rates settle out the Russell should start to trade better. We hope that happens soon – there’s a lot of money to be made in small caps when investor psychology shifts.