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The Big Thing in Small Caps

  • US small caps have outperformed as investor sentiment recovers from Q3 lows

  • Further relative strength is likely among cyclicals which comprise more than half of the S&P SmallCap 600

  • While absolute valuations don’t scream value, the smalls have dropped back to cheap levels relative to large caps

Recent Small Cap Strength

We’re checking back on our bullish 6–12-month outlook established in August. At the time, money was flowing (or fleeing?!) out of small cap equity funds and investor positioning was defensive. After the Russell 2000 peaked in mid-March and as earnings have improved throughout the year, valuations are more favorable. Two months after our original article, US smalls have rebounded after dipping in September.

There’s still work to be done. Who hasn’t seen that ugly year-to-date chart of IWM? We assert that small caps are attractive versus large caps based on relative valuation, a sentiment shakeout, and the group’s sector tilt given the current macro/cyclical situation. Traders who are overweight the group should stay the course.

Higher Rates Are a Boon

Driving outperformance lately has been rising bond yields. While history shows little support for the narrative that increasing interest rates hurt large growth stocks, correlations can change. A one-year chart of your favorite large cap tech ETF overlayed with TLT or IEF clearly shows a relationship. A positive correlation holds for domestic cyclicals—as yields have risen this year, small stocks have outperformed.

Cyclicals Charging Ahead

Digging deeper, it’s the composition of US small caps that stands to benefit from a more optimistic economic growth scenario. We talked about a “second wave of the economic recovery” that would likely see value stocks leading the way.

Indeed, that thesis has taken shape over the last few weeks. The S&P SmallCap 600 index has a 55% weight in Cyclicals whereas the S&P 500 has a mere 25% weight. Tech stocks make up half of US large caps and less than 30% of the S&P 600. As rates rise, cyclicals tend to beat tech stocks, hence small equities have had the advantage over the last 52 weeks. In fact, cyclicals are a bigger share of the S&P600 today than at any other time in the last 20 years.

Featured Chart: US Small Caps’ Cyclical Tilt

chart of US small cap equities sector composition

Looking Ahead

What might fundamentally cause a more positive business outlook for smaller firms? An uptick in real economic activity, a capex boom, high demand for commodities, and backlogs unwinding. All of these scenarios seem plausible in the next year. We discuss several of these factors in our Weekly Macro Themes report.

Don’t underestimate Central Bank policy implications either. Barring a catastrophe, the Fed will start tapering next month. The market also believes a rate hike is in the offering—perhaps as soon as June next year. Again, rising rates favor an overweight to small issues.

Intriguing Relative Value

We study flows, positioning, macro indicators, and of course valuation. The relative value picture is favorable for the S&P 600 and Russell 2000 indices. With the S&P 100 mega cap index beating the S&P 600 over many timeframes, small caps now comprise just 2.5% of the S&P 1500 (total US equity market)—below its long-term average near 3%. The Russell 2000’s relative valuation is a full standard deviation below its long-term average versus the S&P 500, underpinning the case for an overweight US small cap position.

What’s more, the S&P 600 no longer trades at a premium to the S&P 100 (though PE10s on both are stretched). And therein lies the caveat: Absolute valuations are high on all of these US equity indices - so it's more about the relative case (i.e. smalls vs large).

Bottom Line: We reiterate a bullish intermediate-term stance on US small caps. Recent rising bond yields have brought about a second wave of outperformance from the group, underscored by strength in cyclicals. We believe this trend persists as the economic cycle progresses. Following investor pessimism in August, flows and positioning are turning up. Finally, the smalls show relative value versus large caps.

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