Time to go small

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   By Guest Blogger Ryan Lewenza

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Last year, after the markets had taken the big Covid-19 drop, we saw a great opportunity to add US small cap stocks back to the portfolio. Thankfully we sold this position a few years earlier due to our concerns of being ‘late cycle’ and the rising prospect of a US recession, and you do not want to hold US small caps in a downturn!

Well, with the big drop, we changed our tune and added this sucker back to client portfolios. And boy are our clients happy we did this since US small caps have been on a tear, up over 50% since last summer. More recently we’ve seen them trade sideways for much of this year and we believe this sideways action is potentially setting up small caps to begin another move higher in the coming months. Basically, I believe we’re just in the third inning of this trade with still lots of innings (i.e., gains) to come.

Today I’m going to walk you through the bull case on US small caps and review some of the metrics and tools we use in coming up with our investment trades.

First, is the state of the US economy and interest rates. US small companies are more heavily impacted by the economy than large companies like say Pepsi or Microsoft. Meaning, their revenues and earnings are more dependent on the direction of the economy. So coming out of recessions, small cap companies will often see a larger rise in earnings, which can lead them to outperform.

As the US/global economy recovers from this pandemic, we should see a synchronous rise in interest rates, which historically has been positive for US small cap stocks. This can be seen in the chart below where I’ve overlaid the Russell 2000 (main US small cap index) with the US 10-year treasury yield. Note how they move together. When interest rates fall, largely due to a slowdown in the economy, small caps tend to underperform. But when interest rates rise, this is generally very supportive to US small cap stock prices.

I see the US economy and interest rates continuing to recover from the pandemic, which should help to drive US small cap revenues/earnings higher, and in turn, stock prices.

US Small Caps Correlate Strongly with Interest Rates

Source: Stockcharts.com, Turner Investments

Speaking of earnings, US small caps look set to deliver much stronger earnings in the coming years relative to US large caps (S&P 500). As seen below, the Russell 2000 is forecasted to deliver earnings growth of 184% this year (over 2020) and 28% in 2022. Contrast that to the S&P 500, which is forecasted to deliver earnings growth of 61% this year (still amazing and why we’re bullish on the US equity markets), and 9% next year.

Having been in this business and analyzing the equity markets for many years, I know that analysts can be overly optimistic with their earnings growth assumptions. So we might not see as explosive growth as current estimates are currently calling for, but I’m quite confident that US small caps will deliver stronger earnings over the next few years, which is a key reason why we’ve added them back to client portfolios.

Earnings Outlook is Much Stronger for US Small Caps

Source: Bloomberg, Turner Investments

Next up are valuations. When looking at the ‘fundamentals’ of a stock index like the TSX or S&P 500, I focus on key factors like earnings growth, valuations, dividend yields, money flow and sentiment. Focusing on valuations, small caps look pretty attractive, especially compared to the S&P 500.

Currently the price-to-book (P/B) ratio for the Russell 2000 is 2.7x versus the S&P 500, which currently trades at an elevated 4.6x. To accurately compare the two I then divide the Russell 2000 P/B ratio by the S&P 500 P/B to derive a ‘relative valuation’. Dividing the 2.7x P/B for US small caps by the 4.6x P/B ratio for the S&P 500 we get a current level of 0.59. Finally, I then compare that to the long-term average, which since 1995 has been 0.71. Readers at this time might be cursing me for all the numbers, especially on a Saturday, so all this essentially means is that US small caps are attractively valued versus large cap stocks.

Russell 2000 P/B Relative to the S&P 500 P/B

Source: Bloomberg, Turner Investments

Almost there!

Finally, I always try to combine the technicals with our fundamental work to improve our odds of being correct in our calls. We can all have opinions of whether an asset, market or stock is attractive or not, using these metrics outlined above, but at the end of the day the price and technical trends confirm whether an asset or market is in an uptrend or not. Price is truth as the expression goes.

Below is the daily chart of the Russell 2000 ETF. It’s in a long-term uptrend and above the rising 200-day MA. Check. As mentioned earlier, you can see that the Russell 2000 has been in a tight trading range of roughly 210 to 230 since early this year. I believe this is due to the rise in Covid cases stemming from Delta, a slight moderation of recent economic activity, and a drop in interest rates. But I see all this reversing and interest rates moving back up. This should then help to boost stock prices and we could see the Russell 2000 breakout from this recent range, and make new highs later this year and into 2022.

Based on both the fundamentals and bullish technical trends we’re pretty bulled up on US small caps. They’ve done very well for clients since adding them but more gains should be in store in the months ahead.

Russell 2000 is Consolidating but Could Breakout Soon

Source: Stockcharts.com, Turner Investments

Ryan Lewenza, CFA, CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Vice President, Private Client Group, of Raymond James Ltd.