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Once a year, there’s a moment in the US stock market when smaller companies get heard. This year it came at the end of June with the annual changes to the Russell 2000 index of small-cap stocks.
The “Russell reconstitution” of its various indices generates about a 50 per cent jump in overall daily trading volumes for the US market as the $10.5tn of funds that track FTSE Russell’s US index family adjust their holdings.
But this was likely small comfort to small-cap followers, who’ve had a tough time of it lately. Small stocks been underperforming large-cap indices and, in terms of investor attention, been comprehensively overshadowed by mega caps like Nvidia which on its own is worth roughly as much as the entire Russell 2000.
“I’ve done two trips in the past 15 months or so to Europe, talking to European investors about moving a little money down market cap in the US. They just don’t have an incentive to do so,” says Steven DeSanctis, US equity strategist at Jefferies. He says the view is “why would we change what’s working to go into something that we think is going to work?”.
It is a similar case with conversations with many US investors I have had, which tend to drift back to Nvidia’s prospects of beating earnings forecasts yet again. But there are still those arguing the case of the benefits of small caps.
“Small caps are a great diversification tool — and liquid relative to a lot of alternative asset classes such as hedge funds, private equity, real estate,” says Philip Greenblatt, portfolio manager and senior analyst at Easterly Investment Partners.
Even for those not putting money to work, smaller companies are worth paying attention to. They often provide better signals about the real economy than giants who can benefit from sweeping trends like the current hunger for generative AI beneficiaries.
From an investing perspective, the health of the market for smaller companies is also important. It’s the Russell 2000, not the S&P 500 that is most often cited as a benchmark by bankers helping to take companies public since it is the market gauge most new listings are likely to join.
So far this year, the Russell 2000 has gained 1 per cent compared with 16 per cent for the S&P 500. Its constituents, following the June adjustments, range from $10.7bn FTAI Aviation, a jet engine maintainer that has outperformed Nvidia over the past year, to 77-year-old Richardson Electronics, a speciality equipment distributor worth $160mn
Compare the moves in the Russell 2000 and the S&P 500 over six months and small caps have only underperformed their bigger cousins this badly at two other points since the 2000 dotcom boom — and even then, barely.
Over the long term however, returns from large and small-caps tend to be far more similar. So what will it take to lure investors down-market this time?
Some certainty about the timing and scope of interest rate cuts from the Federal Reserve is probably the biggest key to nudging would-be buyers off the fence.
“Either the Fed will cut rates because we’re heading into a recession, or they’ll cut because inflation is declining and we can reboot economic growth. I don’t think people know yet which is going to show up,” says Peter Kraus, founder of Aperture Investors, an active manager. “If you think there’s a recession coming, then big stocks will do OK. But if there isn’t one, then small-caps can rise dramatically.”
Analysts are forecasting a pick-up in earnings for small-caps later this year and into 2025 as the economic outlook clears.
“Investors haven’t had a reason to move — yet,” says Kraus’s colleague Brad McGill, portfolio manager of the firm’s small-cap equity fund. “The risk is falling into the trap of thinking you can pick the bottom but most people actually can’t. The problem with waiting is that historically, these gaps can close quickly.”
The looming second-quarter earnings season might shake-up some thinking. Even if small-caps don’t show the improving results predicted for later this year, profit growth is expected to slow for many of the megacap darlings.
“There’s no denying these are great companies. It’s just a question of what you pay for that,” says DeSanctis. “If earnings growth broadens, you have a choice. You can find other companies that are growing double-digit earnings, and they’re trading a lot cheaper.”
So watch for any pick-up in the Russell 2000 as the year progresses. Signs of increased interest this far down the market would suggest big shifts in investor thinking are under way.
