Photographer: Michael Nagle/Bloomberg

Stock Naysayers Can't Skirt Inconvenient Truth of Small Caps

  • Return to risk-on trading sets up longer run for small caps
  • Weaker balances sheets no longer shunned as credit eases

From tepid volume to an earnings recession, there’s been no shortage of reasons for investors to question the rebound that’s restored $1.7 trillion to U.S. stocks after a January selloff. Yet, there’s no denying the bullish signal emanating from one corner of the market.

The Russell 2000 Index has surged more than 13 percent from its February low, and past resurgences in risky shares have proven a boon for the market. In the three instances since 2009 that the gauge has jumped at least that much so fast, it’s rallied another 31 percent on average over the next year, 16 percentage points more than in any 12-month period during the bull market. The Standard & Poor’s 500 Index has always followed, rising 24 percent.

While it isn’t unusual for so-called small capitalization, or cap, stocks to lead equities out of downturns because they tend to suffer more in declines as investors seek out the more liquid shares of bigger companies, the speed and force of the recovery is what’s gaining attention. That’s because the profits of those companies are typically more closely tied to the U.S. economy.

“When smaller companies are outperforming, it suggests that there is a broadening of domestic economic strength and increased momentum,” said Alan Gayle senior strategist for Atlanta-based Ridgeworth Investments, which has about $42.5 billion in assets. “I’m hopeful that as the year unfolds we will see broader economic strength and if that’s the case, small caps should benefit. It’s something we’re all rooting for.”

The Russell 2000 has surged to the highest level in two months, with four-fifths of its members advancing since a Feb. 11 low. All nine main groups rose at least 4 percent, led by a 35 percent jump in energy shares. Seventy Seven Energy Inc. and Fifth Street Asset Management Inc. are among 15 stocks that at least doubled in value.

The S&P 500 fell 0.3 percent and the Russell 2000 Index gained 0.5 percent at 10:31 a.m. in New York.

The turnaround for U.S. equities weeks after recession anxiety delivered the worst start to a year on record hasn’t been without detractors, as initial gains came amid the year’s weakest trading volume, corporate profits fell a third straight quarter and tumult persisted in China. 

The Russell 2000 has outperformed the S&P 500 by at least 1 percentage point in each of the past three weeks, the longest stretch of such dominance since 2010. While the relationship doesn’t always hold, history shows the economy has a tendency to accelerate after small caps outperform stocks with larger market values.

Since 1979, there have been eight times when the Russell 2000 beat the S&P 500 over three quarters or more. All but once, growth sped up a year later, with the rate of gain in gross domestic product rising by 1 percentage point on average, Bloomberg data show. In contrast, when small caps trailed the large-cap index, the rate of expansion slowed one year later.

“By going into small caps, investors are saying they certainly don’t expect a recession,” Greg Estes, fund manager who oversees about $700 million at Jacksonville Beach, Florida-based Intrepid Capital Management Inc., said by phone. “They’re looking at the more domestic-focused small caps as a place to go back into, with the U.S. looking a lot better relative to everyone else.”

While it’s too soon to say with authority small caps are signaling an uptick in growth, far more convincing is what the latest surge portends for the market. Rallies of at least 13 percent over 15 days during the bull market have been followed by outperformance over the following three- and 12-month periods. In the shorter time frame, the small-cap index has gained 14 percent, 10 percentage points more than normal. That implies a level of 1,193 in early June, after the index closed Friday at 1,081.94.

The rally hasn’t happened in a vacuum, as the S&P 500 capped its best three-week period since 2014, crude surged more than 25 percent from a 12-year low and investors poured record amounts into the largest junk-bond exchange-traded fund. The rebound also accelerated amid speculation some shares fell too far too fast. The 26 percent plunge in the Russell 2000 since June pushed the average price-to-earnings ratio to a three-year low of 31 in mid-February.

Fears of defaults in the oil patch sent energy-related companies in the Russell 2000 tumbling to the lowest in almost 13 years on Feb. 11. Since then, the group has surged the most in the index as crude rebounded above $35 a barrel. During the same period, material producers posted a 17 percent gain after falling the most from June.

Advances have spread beyond the commodities groups, as financials rose 12 percent after hitting the lowest level since 2013 on concern that energy defaults would damage balance sheets. Technology and consumer discretionary shares, which account for almost one-third of the Russell 2000, surged more than 15 percent since Feb. 11.

Optimism the rally will continue is also showing up in the options market, where traders are driving down the price of protection against losses in small caps. After reaching the highest since 2014 on Feb. 17, the cost of contracts on an exchange-traded fund that tracks the Russell 2000 has fallen 49 percent versus contracts on the SPDR S&P 500 ETF Trust, according to data compiled by Bloomberg.

“Just a few weeks ago, we were looking at concerns of these companies not being able to generate sales growth and earnings coming off,” Estes said. “Now it’s been a complete one-eighty. It’s pretty amazing.”

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