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Not terrified of a recession? These stocks hint you should be

Brian Sozzi
Editor-at-Large

Sometimes in life it’s the smallest things that speak the loudest.

Take the Russell 2000 (^RUT), the one-time darling among investors following the election of President Donald Trump. The small-cap index has severely underperformed the Dow Jones Industrial Average, S&P 500 and Nasdaq Composite these past three months by tanking a worrisome 8%. That dismal showing is despite another solid earnings season that saw double-digit profit growth for many companies.

Seeing as the Russell 2000 measures the performance of mostly small U.S. centric companies, it’s ongoing weakness suggests a sharp slowdown in domestic economic growth in early 2019. It could also be hinting at a mild recession in the U.S. spurred by a recipe of rising interest rates and waning effects of the Trump tax cut stimulus.

Why it should matter to you: The Russell 2000’s less than inspiring performance could be boiled down to several factors, said SunTrust Chief Markets Strategist Keith Lerner. As the Federal Reserve charts a path to at least four interest rate hikes in 2019, it will become more challenging for weaker companies — like many in the Russell 2000 with small operations — to access capital. Lerner notes that about one-third of Russell 2000 companies have not produced earnings over the past twelve months.

Further, the cost of debt for those companies that do manage to raise funds is on an uptrend. In turn, that has an outsized impact on the bottom line of smaller companies.

“There are concerns that U.S. economic growth will slow next year from this year, hurting small caps,” Lerner adds. Investors are pricing in that strong probability today by way of the Russell 2000. 

Small-cap stocks continue to be under pressure.

The said economic slowdown may not just be of the typical garden variety, either. 

Recession risk for 2019 is hovering near a two-year high, according to JPMorgan strategist Jesse Edgerton. “Over the last month as survey readings have trickled out in the wake of the market sell-off, the probability of recession within one year has drifted up,” Edgerton said. JPMorgan estimates there is a 32% chance of a recession within the next year, up from 25% seen for much of 2018. 

Yahoo Finance by the numbers: Even with small-cap stocks well off their late August 2018 record highs, they are far from screaming bargains. The Russell 2000’s forward price-to-earnings multiple of 14.9 times is about 3% below its long-term average, according to Bank of America Merrill Lynch data. But, the small-cap index continues to trade at a premium on many other valuation metrics, such as price-to-sales and price-to-cash-flow ratio.

“Small-cap fundamentals have weakened. Our small-cap earnings revision ratio has fallen below average for the first time in two years, with more cuts than raises to estimates. And guidance — which typically leads revisions — has been much weaker for small caps this earnings season, where management is guiding below consensus nearly 2x as much as above. Small caps have also seen weaker earnings growth and fewer earnings and sales beats than large caps in the third quarter, with growth decelerating,” wrote Bank of America Merrill Lynch strategists. 

The bottom line: Mix in formerly hot stocks like Facebook, Apple, Netflix and Alphabet — the group known as ‘FANG’ on Wall Street — dropping 5% on average month-to-date, and there is reason for investors to be more cautious than normal.

And who said gridlock in Washington DC would be positive for stocks, certainly not those being left holding the bag in small-cap stocks currently. 

Brian Sozzi is an editor-at-large at Yahoo Finance. Follow him on Twitter @BrianSozzi

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