Why Small Caps Lag In This Economic Downturn

At a Glance

  • Prior to COVID-19, lower rates from the Fed should have created an optimal opportunity for the Russell 2000 to outpace large cap indices
  • The Russell 2000 flashed warning signs of an economic pullback throughout 2019

Since early 2019, the Russell 2000, the primary index for small cap stocks, has lagged mid and large cap benchmarks.

Many investors consider the Russell 2000 the most comprehensive indicator of the U.S. economy due to its breadth of industries as well as most companies’ central exposure to the United States. In general, small cap companies tend to appreciate more than large caps during periods of economic growth because of their lower valuations and higher level of debt. Companies with under a $2 billion market cap meet the criteria to be considered small cap.

Over the past year, the Fed has lowered rates to help artificially stimulate the economy.  Prior to the Covid-19 economic conditions, these actions should have created an optimal opportunity for the Russell 2000 to outpace large cap indices, but that has not been the case due to the environment’s artificial nature. It is understandable why small cap stocks were hit even harder by the Covid-19 outbreak, but why have their growth cycles lagged that of mid cap and large cap stocks significantly?

Flashing Signs of A Pullback

Christmas Eve in 2018 marked the bottom of a tumultuous year for stocks. Since this Christmas Eve bottom, the NASDAQ, S&P 500 and Dow Jones Industrial averages increased 38.10%, 18.25% and 4.51% respectively, while the Russel 2000 decreased by almost 3%.  Even before the Covid-19 sell-off, small caps were underperforming large caps as the 10-year economic growth cycle was beginning to slow down following a record 10-year bull market.

Although the COVID-19 outbreak is a black swan event and could not have been predicted, the Russell 2000 flashed warning signs of an economic pullback throughout 2019 as it failed to retest all-time highs even though the S&P 500 and other large cap indices kept setting new records. As of the end of April, the Russell 2000 is still about 21% off all-time highs set in August 2018 but has also retraced over 50% of the sell-off from its low on March 18.

Tech Sector Shortage

Another reason the Russell 2000 has underperformed relative to S&P 500 is the composition by sector of the indices. The best performing sector in 2019 was technology, led heavily by Facebook, Amazon, Apple, Netflix, & Google (FAANG). According to Siblis Research, as of December 31, 2019 the S&P 500 was comprised of 10% FAANG and in turn technology accounted for 23% of its total value. allowing the technology sector to pull the S&P 500 with it.

The Russell 2000, which is more diversified, was comprised of only 13.5% in the technology sector. The technology sector increased by 50.3% in 2019, 18% ahead of the Communications sector, the next best performer.  Similar to the technology weighting, the Communications sector accounted for 10.4% of the S&P while only accounting for 2.3% of the Russell 2000. Finally, the second worst performing sector in 2019 was Healthcare, and the Russell 2000 was overweight 4% compared to the S&P 500.

A Forward Indicator Again?

The Fed’s market backstop and reluctance to allow the economy to enter a natural pullback, as well as the composition of the Russell 2000 index, created an environment that did not promote a small cap comeback the way large cap stocks were able to.

However, if small cap stocks and specifically the Russell 2000 are a forward indicator of the economy, we may be approaching a breakout zone if the Russell 2000 gains begin outpacing those of the S&P 500 and large caps. According to Stephen Mathai-Davis, CEO of Quantalytics AI, “during the rally at the start of Donald Trump’s presidency, for every one unit gain in the S&P 500, the Russell 2000 was going up nearly one-and-a-half times.”

Although this recovery will be much different because of Covid-19 and the effect that it is having on small business, the Russell 2000 could again be an indicator once the economic tide begins to turn.

Scott Bauer graduated with honors from the University of Illinois Business School, Urbana Champaign, in 1988 with a B.S. in Finance. Bauer began floor trading in 1991 and formed BOTTA Capital Management in 1995. Scott traded equity options, S&P options at CME and was employed by Goldman, Sachs & Co. as Vice-President, Equities Division. He is currently CEO of Prosper Trading Academy and appears regularly on CNBC, Bloomberg Financial and Fox Business as a guest commentator.

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