Unlike the S&P 500, which recently took out the quadruple top of 2800 set in Q4 2018 and March 1st 2019, US small caps seem to have hit an air pocket.The one-month return data tells the story:
- S&P 600 Small Cap: down 3.2% in the last 30 days
- Russell 2000: down 1.1%
- S&P 500: up 1.9%
- Also worth noting: the S&P 500 is now beating the 600 YTD, up 13.0% versus 12.5%. The Russell is still outperforming the 500, however, up 15.7% on the year.
That small caps should fall by the wayside in the last month seems odd. With less international exposure, they should be better insulated from worries over Chinese and European economic slowing. Low rates also help this asset class, since they sport higher multiples than large caps. The numbers here: 22.3x future earnings on the Russell and 16.8 for the S&P 600, versus 16.4x for large caps.
So what’s going on? We have two explanations:
#1: As we explained a few weeks ago, US small caps are notably levered to the cost of high yield debt. Some 30% of the companies in the Russell, for example, do not generate a profit. That leaves small caps more beholden to debt market pricing and credit availability than large caps.
Data from the St Louis FRED database on the spread between junk debt and Treasuries shows that:
- While non-investment grade spreads have come in from January to now by 150 basis points (544 bp then, 395 now), they remain 50 bp above levels from most of 2018.
- High yield spreads also took a tick higher in early March, going from 386 bp on the 1st to 418 on the 8th. Current levels are still below the March 1st lows of 386. And it doesn’t seem a coincidence that the Russell hit its 2019 high point on March 1st as well…
- You can see the whole chart here: https://fred.stlouisfed.org/series/BAMLH0A0HYM2
Bottom line: at a macro level, recent US small cap weakness can be entirely explained by the backup in high yield spreads. Until those start tightening again (with greater confidence in the US economy), small caps should continue to struggle.
#2: The sector weightings in the Russell 2000/Small Cap 600 differ greatly from those in the S&P 500. For example:
- The Russell has 440 bp greater exposure to Financials than the S&P 500. The Small Cap 600 has 477 bp more exposure.
- Both small cap indices have much heavier weightings in Industrials as well. For the Russell, it is a 507 bp differential. In the Small Cap 600, it is a 931 bp difference.
You can guess where this is going: small cap Industrials and Financials have dramatically underperformed their large cap peers over the last month:
- Large Cap Financials 1-month return: +0.8%
- Small Cap Financials 1-month return: -4.8%
- Large Cap Industrials 1-month return: -1.6%
- Small Cap Industrials 1-month return: -4.8% (and the worst performing sector in the small cap space over the period.)
Bottom line: overweighting sectors that are not working is a sure path to underperformance in active management and index investing alike.
Summary: the recent rough patch for US Small Caps is due to both macro factors and important differences in index construction when compared to Large Caps. High yield spreads are the indicator to watch for a turn, as is the performance of small cap Financials and Industrials.