Smaller U.S. companies, which have been lagging behind their larger counterparts in the stock market for three years in a row, appear to be regaining favor and could take the lead next year.
Among five strategists surveyed by Bloomberg, four expect small-cap stocks to outperform in 2020. Steven Desanctis at Jefferies, in particular, forecasts the benchmark Russell 2000 to rise 7% to 1,750 through next December. That’s higher than the 5% increase that the firm predicts for the S&P 500, a counterpart gauge for large-cap stocks.
While not a huge amount, better gains would mark a reversal from the past three years, when the Russell 2000 trailed the S&P 500 annually in a streak of sub-par returns not seen since 1998. Small-caps have started picking up momentum in recent months as optimism over trade talks and the economy helped restore appetite in a group that by some measure is trading at a 18-year low relative to large-caps.
“Small-caps could be the place to be,” Dan Veru, who helps oversee $2 billion as chief investment officer at Palisade Capital Management, said in a telephone interview. “You’ve seen the underlying strength of the economy. If we do in fact get a trade deal, that’s going to make those more U.S.-centric companies much more exciting.”
To be sure, with the Russell 2000 climbing 21% in 2019, the return is far from disastrous. But in a market where the S&P 500 is up 25%, it looks less stellar. Smaller companies lost their allure as profit slumped the most since 2009 and frequent recession fears drove investors into the safety of larger firms. The pendulum may swing back in their favor in 2020 as economic indicators from truck orders to manufacturing are poised to turn the corner, strategists say.
“We expect small caps to outperform large caps in the coming months as we shift from ‘Downturn’ to ‘Recovery’ in the U.S.,” Jill Carey Hall, a Bank of America strategist, wrote in a note last month. She forecasts the Russell 2000 will beat the bank’s projected 5% return for the S&P 500 next year.
There are signs that sentiment toward the sector has been improving in recent months. After positioning defensively for much of 2019 and fleeing exchange-traded funds tracking smaller companies, investors have come back to the strategy. Small-cap ETFs have seen inflows in three of the past four months and are on pace for net inflows this year -- albeit their smallest since 2012. Overall, investors have added $3.8 billion to the funds in 2019, the data show.
Still, not everyone shares the positive view on small-caps. Ned David Research continues to favor large companies into next year, saying the group is more vulnerable to downturns should the 10-year economic expansion unravel.
Here’s more on what strategists are saying about the sector’s outlook:
BofA Head of U.S. Smid Cap Strategy Jill Carey Hall
Bank of America recommends owning small caps vs large caps in 2020, a reversal from this year’s positioning.
Hall said one key indicator to watch is the Institute for Supply Management manufacturing index, because it’s the most correlated with small-caps. Even as the measure contracted for a fourth straight month in November, BofA sees “multiple signs the ISM could be troughing,” she wrote, citing rebounding truck orders, improvements in the OECD Composite Lead Indicator, and the bank’s own industrial momentum indicator.
BofA also holds the view that “globalization has peaked” and capital markets will undergo a shift toward “local” from “global” as companies work to reduce their exposure to the trade war with China. In a parallel rotation, investors will prefer value over growth stocks as earnings growth picks up, strategists noted. That tends to benefit small caps, which have a larger weight in value than large caps, Hall said. She cited cyclical sectors like industrials as having the most upside.
RBC Head of U.S. Equity Strategy, Lori Calvasina
The bank upgraded small caps to a modest overweight from neutral previously. Calvasina said the group continues to be “deeply undervalued” relative to their larger peers, with the gap sitting more than 1 standard deviations below the long-term average.
Asset managers have taken notice as Russell 2000 futures positioning has started to “turn up meaningfully,” she said, citing data from the Commodity Futures Trading Commission. “Note that the re-engagement is happening pretty quickly, and it’s possible that we’ll be back to past peaks on this indicator fairly soon,” Calvasina wrote.
The strategist noted that small-caps tend to move with the Chicago Fed National Activity Index (CFNAI), Cass freight shipments, and the yield curve. The CFNAI has started to show signs of improvement, the annual decline in Cass freight shipments has stopped worsening, and the yield curve has steepened, all signs that economic activity might be firming, she said.
Jefferies Smid Cap Strategist, Steven Desanctis
As investors await developments on the trade front, Jefferies assumes “something gets inked in ‘20 ahead of the election,” DeSanctis wrote. However, regardless of trade news, the strategist sees the economy growing 2.5% next year and the Fed standing pat on rates. Economists surveyed by Bloomberg forecast 1.8% in real GDP growth in 2020.
An accomodative Fed, better growth, and a weaker dollar will more than offset potential market volatility stemming from “lots of DC drama,“ the strategist wrote. He upgraded materials to overweight while warning that utilities may be the most expensive group in the small-cap space, with limited earnings growth ahead.
Ned Davis Research, Chief U.S Strategist Ed Clissold
Small-caps are trading near their cheapest level relative to large caps in 18 years, so there is potential for a mean reversion, strategists led by Clissold wrote in a note last week. However, they cautioned that a “mature” economic cycle doesn’t favor small-caps.
“Our macro team’s expectation for the expansion to continue deep into 2020 means that the economic cycle will continue to favor large-caps,“ they wrote. NDR forecasts 1.8% real GDP growth next year.
What Bloomberg Intelligence Says:
Additional boosts to risk appetite in the form of further interest-rate cuts or solutions to longstanding policy headwinds are likely necessary to drive small-caps back into a leadership position over the S&P 500, in our view. While relative valuations for the size are certainly attractive, low multiples in isolation aren’t enough of a reason to chase risks and must be accompanied by some positive catalyst to propel the index above previous highs.
We look to a bottoming in the ISM manufacturing index and a narrowing of high yield spreads back toward 2018 levels as additional confirmation of a lasting Russell 2000 rally.
-Gina Martin Adams, Chief Equity Strategist
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