In the world of investing, there's a common saying: "Never buy new lows." And right now, U.S. small-cap stocks serve as a classic example of why that advice holds true.
While the U.S. stock market experienced a summer rally, it has since lost its momentum. Large-cap stocks have been hit hard by rising Treasury yields, but their smaller counterparts have fared even worse.
The small capitalization Russell 2000 index (RUT), which consists of the smallest 2,000 companies within the broader Russell 3000 index (RUA), has seen a staggering decline of over 14.4% in the past three months. In comparison, the S&P 500 (SPX) has fallen 6.6% and the Nasdaq Composite (COMP) dropped 6.8% over the same period, according to FactSet data.
To make matters worse, the Russell 2000 is currently down nearly 6% in October alone. If this trend continues, it will mark the index's third consecutive month with a decline of at least 5%, as well as its first October decline since 2018, as reported by Dow Jones Market Data.
On Monday, both the Russell 2000 and the S&P Small Cap 600 index (SML) hit their lowest levels since September 30, 2022. In stark contrast, the large-cap benchmark S&P 500 finished Monday at a staggering 15.6% above its 52-week low of 3,647.42, as shown by FactSet data.
So what's behind the struggles of U.S. small caps? Nicholas Colas, co-founder of DataTrek Research, believes there are several factors at play.
For starters, five out of the 11 sectors of the S&P 600 - Technology, Health Care, Financials, Materials, and Real Estate - have experienced declines of 17% or more since July. In contrast, no large-cap sector has seen such steep declines. This discrepancy highlights the vulnerability of small caps in the current market climate, as mentioned by Colas in a recent note.
In addition, large-cap stocks have a heavier concentration in the technology sector, which has fueled much of the U.S. stock market's gains this year. On the other hand, the large-cap index has a "notably lower weighting" in financials, a sector that has underperformed the overall market in 2023 due to higher interest rates causing significant strain on the U.S. banking system.
Colas summarized these observations by stating, "Just three sectors - Tech, Health Care, and Financials - are collectively responsible for the S&P 600's underperformance relative to the S&P 500 since the July 31st highs." In essence, the S&P 600 has overweighted poorly performing sectors (refer to the chart below for details).
Further Analysis: Small-Cap Index's Second 'Death Cross' of the Year
The Attractiveness of Large Caps vs Small Caps
Small-cap companies are often seen as attractive investment opportunities due to their growth potential. However, it's important to note that these companies can also be more sensitive to market volatility. This is because they typically have less financial cushion compared to their larger counterparts.
In light of recent market pullbacks, many investors have been opting to park their capital in large-cap stocks. Recent economic changes, such as higher interest rates and rising bond yield spreads, have had a disproportionate impact on small caps. Additionally, the ongoing conflict in the Middle East between Israel and Hamas has further added to the challenges faced by small-cap companies. These factors contribute to their higher cost of capital and generally weaker competitive advantages.
David Colas, an expert in the field, has shared his insights on the matter. According to him, the recent decline in both the Russell 2000 and S&P 600 indexes suggests that this trend is far from over. In light of these circumstances, Colas recommends that investors stay focused on large-cap stocks for now. He believes that resolutions to the two main challenges currently facing small caps - interest rates and geopolitical tensions - need to emerge in order for the sector to regain its strength.
However, Colas does caution that even if interest rates decrease, this may not be enough to stabilize small caps. Investors seeking safe haven assets due to escalating tensions in the Middle East could still impact their performance negatively.
While small caps are not typically Colas' preferred choice when it comes to U.S. equities, he emphasizes that there will undoubtedly be great buying opportunities in this space when the time is right. However, he does not believe that this time has come just yet.
It's worth noting that both JPMorgan's Jamie Dimon and BlackRock's Larry Fink see parallels between the current market climate and that of the 1970s.
Amidst these insights, U.S. stocks on Tuesday showed positive movement driven by strong earnings reports. Treasury yields also seemed to stabilize after touching 5% in the previous session. The Russell 2000 index saw a 0.7% increase, rising to 1,678, while the S&P 600 index was up 0.6% at 1,089. The large-cap S&P 500 index also experienced a 0.7% rise, reaching 4,246. The Dow Jones Industrial Average (DJIA) advanced 0.7%, and the Nasdaq Composite closed with a 0.9% increase during the final hour of trading, as reported by FactSet data.
