What Small Caps Might Be Telling Us About the Economy and the Market

For a big country, we sure have an affinity for little things. Think TV shows: “Tiny House Nation”; sayings: “Big things come in small packages”; and children’s books: “The Little Engine That Could” as being among the more obvious examples of our love of things little or small. It is a love of small things which brings us to the focus of this week’s Weekly Wire, US small cap stocks, and what the asset class might be telling us about the US economy and the US stock market as we approach the second half of 2020.

At the risk of oversimplifying things, US small cap stocks – relative to large cap stocks – are typically more domestic facing, economically sensitive, riskier, volatile, in greater need of capital, and less profitable. As such, they tend to do well on a relative and absolute basis when the economy is strengthening, capital markets are supportive of growth, and investors are more optimistic than not. Considering what the US economy has endured in 2020 you are likely not surprised to read that the Russell 2000 – the benchmark for US small cap stocks – was off approximately 16% year-to-date and 3% on a trailing 12-month basis through May 31, compared to a loss of 5% and a gain of 13% for the S&P 500 Index (S&P 500). During periods of great uncertainty, we should expect big to do better than small. What is more interesting to us are the relevant return streams for the Russell 2000 and the S&P 500 during the second quarter through May 31 – up 21% and up 18%, respectively. While two months don’t necessarily a trend make, we find it encouraging small is gaining on big, which reflects a growing – and we think reasonable – consensus that corporate borrowing conditions have improved dramatically and the US economy has bottomed out. As it concerns small cap stocks and the outlook for – well, small cap stocks – research firm Strategas notes that when small cap stocks have done as well as they have of late (based on return, the percentage of small cap stocks trading above their respective 50-day moving average and the percentage of small cap stocks trading at a 20-day high), returns for the asset class looking out six to 12 months tend to be well above average.