JPMorgan Sees Small-Cap Stocks' Time on Top Coming to an End

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(Bloomberg) -- Small caps have stolen the limelight.

The Russell 2000 Index sits just points away from the all-time high reached in January, roaring back from the February selloff amid a combination of a strong domestic economy, surging corporate earnings, a boost from tax cuts and some stress in the international arena that’s dented the appeal of larger multinational companies.

It won’t last, warns Eduardo Lecubarri, JPMorgan Chase & Co.’s global head of small- and mid-cap equity strategy. Equities closely linked to the health of U.S. economy will bear the brunt of selling if the market susses out signs of stress, he said.

"At some point the market will start to sell SMid in anticipation of a recession," Lecubarri said in an interview Wednesday.

For now, small-cap valuations are at their highest levels of the year versus bigger companies, as measured by the spread between the estimated price-to-earnings ratio of the Russell 2000 compared with the S&P 500’s. The Russell gauge is up 4.7 percent this year, more than double the large-cap benchmark’s advance.

Lori Calvasina, head of U.S. equity strategy at RBC Capital Markets LLC, says signs of stress have already emerged, and will soon create trouble in the small-cap index. She said in a note on Monday that smaller stocks aren’t keeping up with large caps on the earnings front.

“For well over a year, Small has lagged Large on the sales beat rate, last seen in 2006–08 before the peak in the bull market,” Calvasina wrote. “Small’s inability to keep up with Large on sales beats helps keep us neutral on Small vs. Large, offsetting other advantages for Small, such as flows.”

Technical analysis could indicate a reversal as well. JPMorgan analyst Jason Hunter points out that the ratio of the Russell 2000 Index to the S&P 500 Index has extended to the upper end of its range over the past year, boosted by the rising dollar. And a weakening “has already started to happen.”

"We’ll see more of a balance, where large caps will actually get their footing -- and it really fits with our S&P view where we think the S&P 500 breaks out to a new high in the summer," he said in a phone call Wednesday.

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