Small businesses are often thought of as the backbone of the U.S. economy. Long before the coronavirus, the Russell 2000 index, which tracks the performance of domestic small-cap companies, peaked at the end of August 2018. A warning sign of a slowing economy struck at the same time, with the peaking of the ISM Manufacturing Index (PMI), a gauge of domestic manufacturing activity. The tandem crest of these two indices is not too surprising as smaller companies that make inputs or provide services for larger entities are typically squeezed first when the going gets tough. Over the long-term, small-cap returns have shown a higher correlation with domestic manufacturing activity relative to mid- and large-cap returns. Despite the peak of these two indices, the S&P 500 Index, which tracks the performance of domestic large-cap companies, went on to return 16.7% from August of 2018 to its height in February of this year; small-cap returns were flat to negative over the same period. During the worst of the market decline, the Russell 2000 was down 44.1%, underperforming the S&P 500 by nearly 10%, and the PMI hit 41.5, a level not seen since the depths of the Global Financial Crisis. What explains the performance differential between these market cap indices and given the close relation to the PMI, what can we expect from small-cap stocks going forward?

Relative to large-cap, the performance gap lies in quality and construction. Many small companies in the index have low cash reserves, no profits, and debt-laden balance sheets. A lack of access to capital pushes small-cap companies to issue debt at higher rates, creating a lower threshold for quality. Additionally, the small-cap index is more cyclical in nature with a 15% total differential between sectors like interest rate sensitive financials and REITs, as well as economically sensitive industrials. Given this, we might expect the asset class to underperform in the twilight of the longest bull market in U.S. history. Secondarily, the small-cap index has broader sector and industry exposure than the S&P 500. As a result, the closure of the U.S. economy may prove detrimental for many smaller-sized businesses.

In evaluating the last two recessions, there is no consistency as to when the PMI will trough. However, U.S. small-cap returns tend to rebound after a trough in the PMI. Investors like to see a strengthening of the economy prior to betting on small-cap. Looking forward, small-cap stocks usually have better relative performance to their large-cap peers coming out of a recession. The Russell 2000 outperformed the S&P 500 in the last two recessions over the one- and two-year periods post-trough by an average of 26% and 94%, respectively. It is possible we are already starting to see a rebound in small-caps. As of May 26th, the Russell 2000 has outperformed the S&P 500 by nearly 5% month-to-date, the majority of which has accrued over the last week. Small-cap stocks have rebounded on broader containment, economic reopening, and optimism around vaccine development. As is true in every economic downturn, the players here are different; the insurgence of COVID-19 has created an unprecedented headwind for the economically sensitive Russell 2000 Index. Predicting sentiment changes is impractical at best, but as the U.S. consumer economy reopens, we hope to see falling unemployment, rising consumer confidence, and a bottoming of the PMI as domestic production ramps up.

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The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

Since the S&P 500 bottomed on March 23rd, the stock market has taken off while economic fundamentals have worsened. As of May 15th, the S&P 500 was up 28.4% from its trough while unemployment stands at 14.7%, April retail sales fell 16.4%, and industrial activity dropped by 15.5%. The S&P 500 has recouped more than 50% of its losses and sits just 15% below its all-time high.

Digging deeper into the underlying performance of the market, it becomes evident that not all of Wall Street has participated in the rebound. Market breadth, which compares the number of stocks that have gained relative to the ones that have declined, has been especially narrow. As a result, the market can be separated into a relatively few “Haves” and many “Have Nots.” The “Haves” are the largest five companies in the S&P 500: Facebook, Apple, Amazon, Microsoft, and Google (FAAMG) and the “Have Nots” are the other 495 companies in the index. Year-to-date as of May 15, 2020, the top five stocks returned 11.8% and outperformed the bottom 495 stocks before, during, and after the market decline. The bottom 495 stocks returned -15.3% year-to-date, representing a 27% performance gap. This leads us to two questions: Is the market rebound warranted? And, will the performance dispersion between the “Haves” and “Have Nots” fade anytime soon?

Equity markets are a forward-looking indicator of economic and corporate conditions. Yes, current fundamentals are not good, but analysts expect economic growth and corporate earnings to rebound later this year and into 2021, along with the development and release of a vaccine that can eradicate further outbreaks of COVID-19. In addition, stock markets often trough before the release of the worst economic data and before recessions end. Therefore, the forward-looking nature of the market seems to justify the market rebound to date.

Regarding the “Haves” and “Have Nots”, the market seems to believe the winners are large Technology companies and the losers are everyone else and/or any company exposed to COVID-19. There is fundamental support to favoring FAAMG. For example, Microsoft reported a 15% increase in sales, Google surpassed revenue expectations despite the potential for a decrease in advertising sales, and Apple has one of the most cash-rich balance sheets in the country. So, it is plausible that these stocks can continue to outperform. The longest period of similarly narrow breadth occurred in the two-plus years leading up to the bursting of the Tech Bubble. Consequently, periods of narrow breadth are often a harbinger of market declines and have “signaled below-average 1-, 3-, and 6-month S&P 500 returns as well as larger-than-average prospective drawdowns.”¹ We know that eventually the other 495 stocks in the S&P 500 will have more attractive fundamentals and will command higher prices. At that point, the return dispersion between the “Haves” and “Have Nots” will normalize, we just do not know when, though it will likely coincide with more positive economic data and greater containment of the coronavirus pandemic.

Print PDF > There’s FAAMG and Everyone Else

¹ Goldman Sachs Portfolio Strategy Research, May 1, 2020. “U.S. Weekly Kickstart.”

The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.