If The U.S. Economy Is So Strong, Why Are Small-Caps Performing So Miserably?
The Key.
You’ve probably heard me say many times over the past several weeks that “small-caps hold the key”. I don’t use that just as some kind of witty catchphrase that I can repeatedly pound on X over and over for impressions. There are several reasons why small-caps really do hold the key here.
At a high level, small-caps relative to large-caps give us a sense as to just how strongly investors are buying into this soft landing/no recession narrative. When the signs of an economic slowdown were there a year or two ago and everyone was pricing in the high probability of a recession, it made sense that small-caps were underperforming. After all, they’re more vulnerable to the effects of a cyclical downturn and are more leverage-exposed than more established large companies.
When conditions were beginning to turn and/or improve, the opposite should have been the case as well. Small-caps should have begun leading as inflation came down, interest rates peaked and recession became a low probability outcome. But they didn’t. Over the beginning of 2023, the S&P 500 has gained 34%, but the Russell 2000 is up just 17%. The S&P 500 has been setting new all-time highs repeatedly for the last three months. The Russell 2000 is still 14% below its all-time high.
The small-cap/large-cap disconnect started around the time that Silicon Valley Bank blew up and it’s never really recovered. Even when the issues with regional banks proved to be relatively isolated, small-caps continued to lag. Even today, the small-cap to large-cap ratio is sitting near its lowest level since the tech bubble.
Doesn’t really make sense if we’re in a new bull market and we keep hearing about how strong the U.S. economy is. Perhaps this is something that rights itself over time, but we really should have seen some kind of extended run for small-caps over the past couple years. There was a strong run in the 4th quarter of last year when the Fed started to telegraph its intentions to cut rates in 2024, but that rally was completely walked back by February.
Since small companies are the heart of the U.S. economy, why are they still performing so relatively poorly when the economy is supposedly doing so well?
The answer is that it isn’t.
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