For awhile there, small-cap stocks were stocks were the toast of the town, benefiting from the cyclical rotation and talk of the reopening.
Then came some March unpleasantness for smaller stocks. Valuations got a little rich, the reopening trade was priced in and small caps ultimately gave back nearly all off their 2021 relative gains against larger fare. “Relative” is the important word there because in total return terms, smaller stocks still look good on a year-to-date basis.
Yes, the Russell 2000 Index and its counterparts struggled last month, but as of April 5, that benchmark resides just 4.08% below its prior record high. That's not even halfway to a correction, nor is it a good reason to ditch smaller stocks. In fact, there are reasons advisors may want to do the opposite and continue having the small-cap conversation with clients.
“First, the next US budget may boost economic growth via spending on infrastructure, on-shoring manufacturing, health care, etc. Small caps are likely beneficiaries as they are much more highly levered to GDP,” according to Bank of America research.
Dollar Dilemma for Other Stocks, But Not Small Caps
It's fair to say advisors are fielding plenty of inquiries about the seemingly undaunted rise of 10-year Treasury yields since last August.
A result of that move is a stronger dollar. The Invesco DB US Dollar Index Bullish Fund (UUP), which measures the greenback against a basket of major foreign currencies is up almost 3% year-to-date and is almost 9% below its 52-week high, indicating the dollar has room to run. While that's often not good news for large caps, smaller stocks can thrive when the dollar soars.
“Second, a stronger dollar is likely given the widening growth differential between the US & other developed economies. Small caps in the US rely much more on domestic revenue than larger companies and so should be relative winners,” notes Bank of America.
About 20% of the revenue generated by Russell 2000 components comes from international, but for S&P 500 companies, that figure is closer to 30% – a comparison that highlights the utility of smaller equities in strong dollar climates.
“Our FX strategists expect USD strength because of the widening growth differential between the US & other developed economies and monetary policy divergence between the Fed and ECB,” notes Bank of America. “This will likely attract more foreign capital to US markets and benefit small-caps, which rely much more on domestic revenue than larger companies.”
Although no small-cap exchange traded funds were among the top 10 asset gatherers in the first, the iShares Russell 2000 ETF (IWM) saw $2.19 billion of inflows. That's relevant because, as of BofA points out, when small-cap ETF inflows top 10% of assets, corrections occur and that already happened this year.
With that in mind, there are some “trough”-inspired tips that advisors can evaluate for keener near-term small-cap revisits.
“Trough in relative prices: the Russell 2000 is down 6% vs. the S&P 500 since flows peaked…the average decline (11%) would be a better moment to buy,” according to BofA. “rough in breadth: the percentage of Russell 2000 stocks trading above their 200-day moving average recently hit a 10-year high, but is now falling. The long-term average breadth is just under 60%.”
Summing things up, this exact moment may not be ideal for overweighting small caps, but the asset class is by no means damaged. Exercising some patience here could help advisors bring value to the small-cap conversation.
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