Bear Market Won’t Stop Gnawing Small Caps Even After Brexit

  • Small caps lead market but two strategists cautious on group
  • July is weakest month historically for Russell 2000 Index

Don’t let the recent rally fool you, U.S. small-cap stocks still are digging out from their wintertime bear-market selloff. And anyone expecting relief this month stands to be disappointed, if history’s any guide.

Sure, the Russell 2000 Index has led the post-February bounce in U.S. equities, surging 21 percent compared with 15 percent for the Russell 1000. But that rally is less impressive considering small-caps plummeted almost twice as much as their large-cap counterparts from the 2015 high, a peak they remain 8 percent below.

That pattern continued Friday, as the Russell 2000 jumped 1 percent as of 9:39 a.m. in New York after a report showed U.S. employers added more jobs than expected in June. That outpaced the 0.7 percent gain for large caps. While the market quickly shook off Brexit and small caps have led the way, two strategists see reasons for caution.

“The market action post the U.K. referendum doesn’t change the story that small caps are a higher-beta, lower-quality risk asset,” said Dan Suzuki, investment strategist at Bank of America Corp. “Over the long-term, say the next 10 years, small caps can do OK relative to the large caps, but just for the remainder of this cycle, small caps are not as good of a risk-reward.”

Even if the knee-jerk reaction to global tumult is to seek safety in companies that derive more of their revenue in the U.S., further spikes in volatility will disproportionately hurt small-cap stocks, Suzuki said. “The U.K. referendum was just the first of a bunch of different catalysts that we expect over the next four to five months.”

More immediately, seasonal trends are working against bulls. July happens to be the weakest month for the Russell 2000 -- it’s declined 0.7 percent on average during the month in the past 30 years. On a relative basis, the performance is even worse. The small-cap benchmark has trailed its large-cap counterpart 73 percent of the time since 1986, by an average of 1.6 percentage points.

That weakness could be explained partly by second-quarter earnings that land in July, according to Steven DeSanctis, equity strategist at Jefferies LLC in New York. This year’s results, which will commence next week, are likely to show a fifth consecutive decline for S&P 500 companies, with further uncertainty as a result of Brexit, he said.

“How can companies give guidance, especially if they have overseas exposure? You’ll probably see pretty cautious guidance for the second half of the year, so I don’t know how that’s going to bode well for the market,” DeSanctis said. “I’ve been very surprised by the strength of the market and how quickly volatility has come down, but I don’t see that as being sustainable given the question marks out there.”

One of those is the strength of the U.S. economy. While recent reports on services industries and consumer spending were positive, Federal Reserve officials held pat on interest rates last month because of heightened concern about the U.S. labor market, according to the minutes of their June meeting. Meanwhile, economists see a 20 percent probability of a U.S. recession within the next year, according to the median estimate of those surveyed by Bloomberg in June.

Even if a recession isn’t imminent, a view espoused by Michael Sheldon of Northstar Wealth Partners, slower economic growth historically has favored large-cap stocks. What’s more, “in a world starved for income,” large caps have the higher yield. The Russell 1000’s is 2.1 percent versus 1.7 percent for the small-cap counterpart

“We favor large-caps over small-caps right now because we’re in the latter part of the economic expansion, there’s a lot of uncertainty around the world, large-cap stocks generally have higher dividends, they don’t have to access the capital markets as much and they have stronger balance sheets,” said Sheldon, chief investment officer at Northstar, which oversees $1.1 billion in West Hartford, Connecticut.

Investors are more bearish on small caps than large caps, but by degrees that trail historical averages for the month of July. At 11 percent currently, short interest as a percentage of shares outstanding for the iShares Russell 2000 ETF is less than half of what it’s been during the past 10 Julys.

While getting a read on sentiment has become difficult since the U.K. referendum, the performance of small-caps is more directly related to investors’ overall risk appetite -- and there are reasons to remain cautious ahead, according to Suzuki. “There’s been a pretty dramatic comeback but I think that just makes them more at risk the next time we see a confidence shock.”

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