Small Caps Emerge Relatively Unscathed in Megatech Bludgeoning

(Bloomberg) -- Small-cap stocks are providing somewhat of a refuge from the rout that tore through equity markets this week, a signal that investors see brighter days ahead for the economy as pandemic lockdowns are lifted.

Even though the group ended the week in the red, the little guys fell a lot less than bigger companies, especially the tech megacaps that had led the surge in stocks since mid-March. In fact, the Russell 2000 index of smaller firms is on pace to have its best month versus the Nasdaq 100 in more than two years.

The relative resilience is a signal that investors think the run-up in companies that benefit from everyone staying at home has run its course, and the best bet now may be the airlines, restaurants, cruise lines and retailers that suffered the most when life went almost entirely online. Of course, many stock portfolios are heavily weighted to the largest companies, so the typical investor could be hit hard right as the real-world economy starts to recover.

“Small caps are going to be more reliant on healthy economies, healthy consumer spending and a healthy global economy,” said Chris Gaffney, president of world markets at TIAA Bank. “If you can see past Covid and see that global recovery continuing, then you see small caps doing better.”

Small-cap companies get a bigger chunk of their profits domestically and generally have weaker balance sheets than their bigger peers, which didn’t bode well for them during a flight to the safest and most stable companies in the midst of the pandemic.

On the flip side, the group is more shielded from geopolitical risks, which are coming to the fore as the U.S. presidential election approaches, tensions with China simmer and Britain’s plan to exit the European Union grows more complicated.

Though far from pre-pandemic levels, a lot of economic data has been improving, with the unemployment rate at 8.4%, better than what many economists had expected at this point. And other data have firmed too, including manufacturing activity, which expanded in August.

But underlying this trend is the slowdown in Covid-19 infections and deaths. Small-cap stocks have outperformed during periods when virus numbers get better, according to Wells Fargo’s Chris Harvey, who advises a rotation into the sector.

Data on exchange-traded funds show investors making the switch over the past week. Through Thursday, investors pulled more than $3.2 billion from the $128 billion Invesco fund that tracks the Nasdaq 100 (ticker QQQ), putting it on pace for its worst week of outflows since February 2018. Meanwhile, they’ve added money to the iShares Russell 2000 ETF (ticker IWM), with the fund on pace for its fourth week of inflows out of five.

Small caps are “an economically sensitive trade. You really need to see the economic recovery take hold,” said Alec Young, chief investment officer at Tactical Alpha LLC. “It’s a little early, but there’s reason to be optimistic about the economy over the next 12 months.”

Since mid-March, megacap tech stocks have skyrocketed, with the Nasdaq 100 gaining about 58%. It’s besting the Russell 2000 by about 10 percentage points in that period. But this week, the smaller-cap gauge had its best stretch versus the tech behemoths since the beginning of August.

Steven DeSanctis and Eric Lockenvitz at Jefferies point out that analysts are growing more optimistic about small caps. The earnings revision ratio for Russell 2000 stocks -- a measure of the number of boosted estimates divided by the number of cuts over the last three months -- reached an all-time high of 1.7 in recent weeks. And the sales revision ratio is well above its long-term average at 1.3, according to data compiled by Jefferies.

There’s another factor helping the smaller stocks these days: Their valuations -- while still expensive relative to bigger firms -- have been trending in their favor.

That implies a much better outlook for gains over the next decade for the little guys, Bank of America strategists led by Jill Carey Hall wrote in a note to clients. Using a historical analysis of price-to-earnings ratios versus subsequent returns, they predict high single-digit annual returns over the next 10 years for small caps, compared with low single-digit returns for large caps.

Chad Oviatt, director of investment management at Huntington Private Bank, says small caps will benefit from any positive developments related to a Covid-19 vaccine. He’ll be looking to add those types of stocks when a shot looks likely to become widely available.

“The economy is rebounding. You are seeing activity pick up in most parts of the country,” he said in an interview. “If we see an additional catalyst for small caps, we may go there, we may add to our position.”

©2020 Bloomberg L.P.