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Small-cap stocks just can't catch a break this year.
On Wednesday, the Russell 2000 (^RUT) closed at its lowest level since Nov. 6, 2020 — just a day before President Biden's election was called by most media outlets. And with this latest move lower, investors are effectively shutting the door on one of the defining pandemic-era trades.
It's worth recalling that small caps were the fastest US stock index out of the gate post-election — rallying 45% in four short months as the Dow, Nasdaq, and S&P 500 registered about half that performance.
But those days are long gone for the small cap trade.
Year-to-date, the Russell 2000 is down 6% as the Nasdaq still sits on a hefty 22% gain and the S&P 500 is up 9%, roughly in-line with its long-term historical average annual return.
Optimism about the economy's recovery from a brief recession was supercharged by Biden's $1.9 trillion fiscal stimulus package passed early in his presidency.
And the more domestically levered small-cap names were seen by investors as the clear winners from this profligate spending. Data from JPMorgan Asset Management published earlier this year found that 22% of revenue for Russell 2000 members comes from overseas; for the S&P 500, it is closer to 40%.
But fast forward a few years and an interest rate tightening cycle has raised the cost of capital and punished companies with smaller market capitalizations that often have more volatile balance sheets and financing needs than their larger peers. And that same JPMorgan study found that at the end of 2021, some 40% of companies in the Russell 2000 were not profitable.
As Yahoo Finance's Josh Schafer recently wrote, Russell 2000 companies have to roll over more debt in the coming years than S&P 500 companies, leading Bank of America's equity strategy team to conclude: "The real risk is in the Russell 2000."
Right now, investors agree.
And the challenge for those betting on a small-cap comeback is that market history suggests the next driver of outperformance is what the US economy continues to push off — recession.
In a recent note, SoFi's head of investment strategy Liz Young flagged that small caps tend to outperform as the unemployment rate shoots higher. That's a strange correlation to ponder, but there are sound fundamentals to explain the tendency.
Job losses tend to accelerate in the late stages of the business cycle, as employment often cracks before we get an "official" recession call from the NBER. So the next time jobless claims shoot higher and the elusive "r-word" definitively rears its ugly head, investors may take a shot at small caps.
Because once the dark recession clouds part and the markets find their footing, small caps typically lead market returns over their larger cousins.
According to Young, data from Morningstar Direct shows that six months after a recession ends, small caps are typically sitting on total return north of 30%, almost double the 16.9% return seen for large caps over the same period. Coming out of the brief pandemic-induced recession in 2020, the Russell 2000 gained 17.4% over the next six months while the S&P 500 rose a more measured 12.3%.
But despite the most dramatic tightening by the Fed in over four decades, the US labor market remains resilient.
This helps explain why small caps did not lead as the current bull market in large caps got underway last year.
And explains why this once-hot pandemic-era trade keeps struggling to turn around.
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