​As Sam Sees It: Small Caps Are Having Their Day in the Sun

Sam Stovall  |

Each week, we tap the insight of Sam Stovall, Chief Investment Strategist, CFRA, for his perspective on the current market.

EQ: Stocks were hit with a dose of volatility this week as political turmoil in Italy added uncertainty to the future of the euro. Last week, we discussed how macro headlines were masking technical drivers in the market. Is this the case or is the current situation in Italy posing major risk to the market?

Stovall: I think it’s certainly posing a different type of risk to the market. We’ve seen the trade tensions be on the table, then off the table as they relate to China. We’ve also been hearing about the conference with North Korea occurring and then not occurring. Yet, the recent Italian elections and the increase in majority of the party that would rather upend Italy’s involvement with the euro has caused many investors to worry that there will need to be an additional election in Italy, which could actually strengthen the party that wants to bolt from the EU. As a result, it has just increased global uncertainty.

But until the technicals indicate otherwise, it still appears as if we are in a global bull market that is simply experiencing a spate of near-term weakness.

EQ; In this week’s Sector Watch, you focused on the performance of the small-cap segment of the market. The S&P SmallCap 600 recently notched a new all-time high and is currently outperforming the S&P 500. What’s fueling this run-up?

Stovall: I think there are four things. First, small caps outperformed the S&P 500 in 2016 and then underperformed in 2017, so I think there’s a bit of reversion to the mean taking place with the new rotation into small-cap stocks. But I think what’s encouraging investors to do this are certainly the international tensions. Since small-cap stocks tend to have little to no international exposure and focus primarily on the domestic economy, they seem to be insulated from a lot of these geopolitical issues.

Also, with the tax cuts that were signed at the end of 2017, the annual benefit (not the repatriation of foreign earnings) really are directed toward domestically garnered earnings, which again, is going to help the smaller companies because that’s where their marketplace is. They don’t really have foreign earnings that they need to translate.

Lastly are valuations, not only on an absolute level but also on a relative level to the S&P 500. The P/E ratios for the S&P SmallCap 600 look attractive by historical standards.

EQ: Interestingly, you pointed out that Small-Caps have tended to hold up better in down markets than the S&P 500. Can you elaborate on that performance?

Stovall: On a month-to-month basis over the last five years, not surprisingly, small-cap stocks have a slightly higher beta relative to large-cap stocks. So, in general, yes, from month-to-month you do end up with more wiggle for the small-cap stocks than the large-cap stocks. However, the two most recent mega-meltdown bear markets were really triggered more by your large-cap firms.

The tech bubble that burst in March 2000 did not take the small caps down with them in 2000 or 2001. It was only in 2002 that small caps joined mid and large caps in the red. The most recent financial crisis was really triggered by large caps and their exposure to the housing market and so forth.

So, what I showed is small caps ended up having fewer mega-meltdown bear markets, and the average decline really has been more favorable for small caps than it has been for larger caps. Granted, the data only goes back to 1978 for the Russell 2000 index and to 1995 for the S&P SmallCap 600, but still, it is interesting that in the two most recent bear markets, they were triggered by the large-cap companies and not the small ones.

EQ: You mentioned the difference in valuation and the size of the longer-term downswings. Considering the reputation that Small-Caps have as being more volatile and risky, why are the sell-offs shallower and recovery time quicker? Should investors reconsider what they think they understand about the small-cap market?

Stovall: I think so. Right now, small-cap stocks are trading at about a 9% discount to their long-term average relative P/E looking at year-end 2019 earnings estimates. So, just from the standpoint of relative valuation, small-caps look attractive relative to what they normally trade at versus the larger companies. Also, we’re currently seeing small-cap stocks in new all-time high territory. Small caps got back to break-even on May 9 from the sub-10% decline experienced earlier in the year, and we are now at new all-time high territory for the S&P SmallCap 600.

The S&P 500, however, still remains more than 5% off from its all-time high. What’s interesting is that while the S&P 500 is still underwater, the movement of the SmallCap 600 has been fairly consistent. Normally, it takes about 31 days to get back to break-even from a decline of 5-10%, which is referred to as a pullback. We have advanced about 2%-plus since that May 9 recovery date. But normally, small caps rise about 8.5% after getting back to break-even, and they typically do so in about 70 calendar days.

What’s interesting though is it typically takes substantially longer for large-cap stocks to post their 8.5% post-recovery high. So, the small-cap stocks tend to make their movements in a sharper V-shaped fashion than the large caps do. The feeling is there is still upside potential left for the small caps based the traditional post-recovery advance they normally see. At the same time, investors are rotating out of large-cap stocks, and they have reason to rotate into the smaller-cap stocks because of earnings growth and a more attractive relative P/E ratio.

EQ: Considering that small-caps have some more room to run, which areas of this market should investors be looking to?

Stovall: I did a screen using CFRA’s MarketScope Advisor research platform and came up with 18 stocks. We have six Industrials stocks that meet the criteria for being in the S&P SmallCap 600 and also have buy or strong buy recommendations by CFRA equity analysts. The second largest group was Consumer Discretionary, which had five representatives, whereas Information Technology had three, and then the other sectors of Consumer Staples, Materials, Energy, Real Estate had one each.

So, predominately the cyclical sectors in the small-cap arena is where our analysts believe have the best upside potential over the coming 12-month period.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer


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