Large-capitalization U.S. stocks are in the midst of an earnings recession, by some measures, but the state of profit growth for small-cap stocks in 2019 has been a disaster on another order.
Earnings for companies in the small-cap S&P 600 SML, -0.75% have cratered this year, falling 16.4% in the first quarter and 10.4% in the second, while on pace to fall 15% in the third and projected to fall 8.9% in the fourth quarter, according to FactSet.
With performance like this, it’s no wonder that the S&P 600 index and the small cap Russell 2000 RUT, -0.67% remain more than 8% below their record highs, reached in the summer of 2018. But these results are also setting up the small cap universe for much easier comparisons next year, and there may be reason to think that the Russell 2000’s recent outperformance of the S&P 500 — culminating this week in a bullish “golden cross” pattern for the small-cap index, wherein its 50-day moving average surpassed its 200-day — SPX, +0.01% will continue in the quarters to come.
“The big thing is that recession fears have receded, and with that people have felt comfortable taking on more risk,” Steven DeScantis, equity strategist at Jefferies told MarketWatch. He pointed out that since Sept. 3, the Russell 2000 has returned 8.6% versus 6.6% for the S&P 500, an outperformance that can be attributed to investors renewed faith that the U.S. economy is not headed for a recession, but for a potential re-acceleration of growth.
“Small cap performance is all about expectations for economics growth, the reduction of recession fears, the steepening of the yield curve and the bottoming out of sentiment with U.S.-China trade in August,” said Kristina Hooper, chief global market strategist at Invesco.
All of these factors have underpinned a renewed optimism among investors that the current economic expansion has room to run, benefitting small cap stocks that are perceived as more sensitive to the economic cycle, as well as “value” stocks that are inexpensive relative to a intrinsic measure of their worth, like price-to-book or price-to-cash-flow.
Indeed, the rotation into small cap stocks can be seen as part of a larger value rotation, as small-cap sectors that are typically associated with the value trade have, in some cases, doubled the already robust recent performance of the broader Russell 2000, according to DeSanctis. Materials stocks in the Russell 2000 have risen 17.9% since Sept. 3, while small-cap industrial stocks have risen 13.8% and financials have gained 10.9%.
It may be the performance of these financial stocks, however, that determine the fate of small-cap indices going forward. 18.2% of the Russell 2000’s market capitalization is reliant on the financial services sector, with banks contributing more than half of that, while roughly 30% aggregate Russell 2000 profits come from the financial sector.
In an environment of low and falling interest rates, it’s difficult for small banks in particular to make money, as their profit margins move proportionately to the Federal Funds rate, DeSanctis said. Though the Fed has cut rates three times this year, hurting bank profit margins, these moves have helped un-invert the U.S. Treasury yield curve. The negative spread between the 10 year U.S. Treasury note and the 3-month U.S. Treasury bill hit 48 basis points on August 28, before it shrank and turned positive, preceding the Russell 2000’s turnaround by a few days. A positive sloping yield curve is more bullish for future bank earnings than an inverted one.
Looking forward, there are positive technical signals forming for small-cap stocks. “The good news for the Rusell 2000 is that small-cap breadth has improved with new year-to-date highs for the Russell 2000 advance-decline line,” wrote Stephen Suttmeier, technical research strategist at Bank of America, in a Monday note to clients.
This trend has coincided with a growing share of stocks in the index hitting new 52-week highs, another sign that increases the “potential for an upside break out” for small cap stocks, he wrote.