Time to think small?
Perhaps. But the focus should be on quality.
Published November 22 2022
A tough year for equities has been even harder on small-cap stocks. No great surprise there. Because of their lack of scale relative to larger companies, smaller companies tend to be more sensitive to changes in the economy—to the upside when growth is accelerating and the downside when it’s decelerating. And because smaller companies typically carry more debt than larger companies, much of it variable, they’re inclined to be more vulnerable to changes in rates. So, in the first half of the year when real GDP contracted and the Fed embarked on its most aggressive rate-hike cycle since the early 1980s, small caps as measured by the Russell 2000 underperformed larger companies as measured by the S&P 500.
The past month, however, has seen smaller companies take the lead. Again, no great surprise. The fourth quarter got off to a relatively strong start—the Atlanta Fed currently has Q4 GDP tracking at 4.2% annualized rate, its best pace since last year. Similarly, futures suggest the Fed is closing in on an end point for its rate-hike cycle. At this writing, the yield on the 10-year Treasury is down 50 basis points from its October cycle peak of 4.25%. Stronger growth and lower rates represent tailwinds for small caps—they’ve outperformed large caps in all six of the six recoveries since 1980, often times meaningfully, Strategas Research says. After the dot.com bubble ended, for example, small caps outpaced large caps by more than 40%, cumulative, from October 2002 to October 2007.
To be sure, one month does not a trend make. There are many reasons growth could slow abruptly in the year ahead—that in fact is the consensus view of the Federated Hermes Macroeconomic Policy Committee. And while the Fed may be nearing a terminal rate, all indications are it will be in no rush to start easing. Futures currently are pricing a peak policy rate of 5.25% through summer. So, caution is merited. That’s why when we think small caps, we’re thinking quality companies that have lower debt, stronger balance sheets and a history of earnings relative to the overall small-cap universe. Since its inception on July 1, 2007, the Russell 2000 Quality Factor Index has outperformed, on a rolling 60-month basis, the broader Russell 2000 Index more than 80% of the time through Q3 2022, according to Morningstar Direct. This would suggest that, in volatile times, quality matters.