The small-cap Russell 2000 index, which is made up of the smallest 2,000 companies in the broader Russell 3000 by market capitalization, recently hit its highest close since March 2023.
During the first week of June, the Russell rose 6.6% compared with a 2.9% gain for the S&P 500.
Some of the biggest individual stock movers in the Russell 2000 over the past month (as of June 15) include Applied Digital Corp (up 55%) and CIRCOR International, Inc (up 64%), with small banks, energy and industrials leading the index’s advance.
Despite the upward move, the Russell 2000 still lags its more prominent US stock indices, rising 5.4% so far in 2023, as of June 6, compared with an 11.6% increase for the large-cap benchmark S&P 500 and a 26.9% surge for the tech-heavy Nasdaq Composite.
But some market watchers believe that the recent strong performance of small-cap stocks, particularly in cyclicals and industrials, indicates a shift in market sentiment away from recession concerns. Small caps are already priced at a discount, reflecting the anticipation of an economic downturn.
In the small cap space, valuations were already steeply discounted compared with long-term averages and relative to large caps, with small caps having priced in a severe economic slowdown.
Analysts at Noble Capital Markets believe June is shaping up to be the month when small caps are the stocks to watch, based on the sector’s performance following the release May’s US employment data on June 2, 2023.
Historically, they wrote, the average return over time is expected to be greater for small caps, thus “large cap stocks either have to begin trending down, the small caps upward, or maybe a little of both”.
The analyst noted the Russell 2000’s 3.6% gain on June 2 was its largest one-day increase in six months, while its 2.8% rally the following Tuesday represents the index’s biggest gain since early March.
Furthermore, at least one equity researcher thinks price/earnings (P/E) ratios on many small-cap stocks are below historical norms and earnings per share (EPS) estimates are beginning to be revised upward.
“Small caps are finally starting to participate in the EPS revisions recovery,” RBC Capital Markets head of US equity strategy Lori Calvasina wrote in a recent research note.
“The rate of upward EPS estimate revisions has moved up to 50% for the Russell 2000,” she added, while noting that more than half the sectors in the index are “now in positive revisions territory for both EPS and revenues.”
Currently, small-cap stocks sell for 14.4 times 2023 estimated earnings, while the S&P 500 is trading at 19.5 times.
Calvarisa highlighted the utilities, consumer staples, healthcare, industrials, communications services, information technology, and TIMT (technology, internet, media and telecommunications) sectors, saying all have both positive EPS and revenue revisions among the small caps.
RBC’s research also revealed that small-cap stocks usually bottom three to six months before EPS forecasts start rising again.
And, the US Federal Reserve’s recent pause in interest rate increases is likely supportive of small-cap stock performance since it raises the likelihood that the US economy can avoid a recession, and small caps tend to be more economically sensitive, according to a recent Forbes article.
All in all, the outlook for small-cap stocks looks increasingly positive as valuations for larger-cap companies, particularly AI-related tech stocks, look stretched and a more positive economic outlook with the possibility of lower interest rates down the road should encourage investors to take greater risks to achieve the outsized returns historically offered by small-cap equities.
Investors wishing to mirror the Russell 2000’s performance have a few ETFs to choose from, including the iShares Core S&P Small-Cap ETF (IJR), iShares Russell 2000 ETF (IWM), Vanguard Small-Cap Value ETF (VBR), Schwab US Small-Cap ETF (SCHA) and iShares Russell 2000 Value ETF (IWN).
Contact Sean at sean@proactiveinvestors.com