A US stocks rally is leaving behind smaller companies, a sign that investors may be bracing for economic turmoil ahead.
The small-cap Russell 2000 is down about 1% this year, compared to a rally that has boosted the S&P 500, an index representing the largest US companies, 7% year-to-date.
Like the inverted US Treasury yield curve and strength in gold prices, the weakness in shares of smaller companies – which tend to derive profits domestically and be more vulnerable to economic shifts than larger firms – is one of several signs that investors are uneasy about the economic outlook.
Small cap stocks have struggled since turmoil in US regional banks erupted in early March, with the Russell 2000 down 7% since March 8. Investors fear that smaller firms will be hit hard by a potential lending slowdown that could weigh on the broader economy.
Investors are “trying to position their portfolios for what they think is going to happen in the economy,” said Eric Kuby, chief investment officer at North Star Investment Management, which specializes in small caps. “Small caps being out of favour is another signal that investors are bracing themselves for an impending recession.”
Small caps have tended to waver ahead of economic weakness in the past. Since 1980, the Russell 2000 has lagged the S&P 500 by an average of about four percentage points in the six months after the economic cycle has peaked, ahead of a recession, according to Strategas data.
Economic data has so far shown few signs of a sharp drop-off in growth, though inflation and some other important metrics have cooled. Still, some market participants believe the Fed’s 500 basis points of rate increases over the past year are only starting to impact the economy.
“We are likely headed into a recession sometime in the next 12 months,” said Michael Arone, chief investment strategist at State Street Global Advisors. “Typically in a recession, small caps underperform.”
At the same time, investors worry that banking instability will hurt smaller US companies that rely on loans from regional banks, which have been at the center of the recent crisis.
Investors next week will be focusing on economic data including monthly retail sales and earnings reports from companies including Walmart Inc, Home Depot Inc and Cisco Systems Inc.
