It's August All Over Again for Small Cap Stocks

  • Hedge funds boost short bets on group to highest since 2014
  • Russell 2000 falls to six-year low versus larger-stock index

The tumble in small-cap U.S. companies that started last summer has deepened, and hedge funds are betting it will get worse.

Down five of the last six days, companies tracked by the Russell 2000 Index slumped 2.7 percent Thursday, falling below a level reached in September and trading at the weakest versus the Russell 1000 in six years. Large speculators are wagering on more pain, boosting short sales on the group to the highest level since October 2014.

Falling prices in assets from crude to Chinese equities have fueled investor worries. Concerns over global growth have overwhelmed speculation that a stronger U.S. dollar represents an advantage for small-capitalization companies, which get a higher percentage of sales from the domestic economy. It’s a repeat of the summer, when the Russell 2000 plunged almost 15 percent in two months, exceeding its larger-stock counterpart’s 12 percent drop over the same period.

The renewed volatility has reduced investors’ risk appetite and optimism on U.S. growth, disproportionately hurting shares of smaller companies, said Jim Tringas, who helps oversee about $4.5 billion as senior portfolio manager at Wells Capital Management Inc.

“The market seems to be pricing in a stronger likelihood of a recession,” Boston-based Tringas said. “Cautious” doesn’t capture investor sentiment, he said. “Fearful might be a better word.”

That dynamic prevailed on Monday, when small caps lagged behind large caps by 0.9 percentage point, the most in almost a month. “That day was unique,” Tringas said. “If you want to decrease your risk profile, you sell small-cap stocks, and that’s more or less what I saw that day.”

Investors are increasingly dour. Data from the Commodity Futures Trading Commission shows hedge funds raised short bets on the small-cap shares at the end of 2015. The last time they were this bearish in late 2014, improving U.S. economic data stoked speculation the Federal Reserve would lift interest rates faster.

The Russell 2000 has trailed the S&P 500 in four of the last six instances the Fed began raising borrowing costs, according to data compiled by Bloomberg. The small-caps gauge has lagged behind its counterpart of bigger shares by an average of 9.5 percentage points in the two years after the central bank boosted rates, the data show.

This time around, economists are reining in their optimism about the prospects for U.S. growth. In June, those surveyed by Bloomberg saw a 2.8 percent expansion this year. That’s since fallen to 2.5 percent, the same as the projection for 2015, data show.

The tailwinds that were expected for small-cap stocks last year didn’t materialize, said Jonathan Krinsky, chief market technician at MKM Partners LLC.

“They were supposed to do well because of a stronger U.S. dollar and they haven’t,” he said.

With investors seeking shelter in assets generally considered to be safer, that makes larger companies a better bet now, said Ross Yarrow, director of U.S. equities at Robert W. Baird & Co. in London.

“With worries about global growth, the smaller stocks traditionally are more volatile and don’t tend to do so well in times of doubt,” said Yarrow. “People are wanting the liquidity and the safety and the bigger cap names.”

Debt at small-caps has also ballooned at a time when investors are discerning over company balance sheets. The net-debt-to-earnings ratio for the Russell 2000 has jumped to 4.06 times from 3.65 times in 2013. In contrast, the ratio for S&P 500 companies last year was 2.02 times, the data show.

The market’s “risk-off tendency since the middle of last year” has weighed on all risky assets, including high-yield bonds, emerging-market equities and commodities, said Venu Krishna, head of equity linked strategies in New York at Barclays Capital Inc.

At the same time, looking at sales and earnings growth in the last 12 months, “it’s hard to justify the underperformance of small caps versus large caps,” Krishna said.

“We have to see tangible signs that U.S. economic growth is better this year than last year,” Krishna said. “That isn’t a clear-cut case.”

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