The last few weeks a concept has taken over the market: the low breadth of the market on Wall Street. This goes to say that only a few companies, specifically the seven largest, are sustaining the bullish behavior of the S&P 500 on the US stock markets in 2023. Smaller companies are not following this rally. For this reason, it is interesting to see the characteristics of the prospects for the ‘small and medium caps’ (small and medium market capitalization values) in the North American country.
There was considerable caution in mid-March regarding small-cap and large-cap stocks due to credit risk, exposure to regional banks and the possibility of increased volatility from debt ceiling negotiations. In this sense, although the Russell 2000 index has lagged the S&P 500, there has been a rebound in recent weeks: credit conditions and regional banking problems have stabilized so far, the yield curve has it flattened out again (historically better for small businesses) and economic data has been more resilient than expected, delaying recessionary entry with a more modest decline in GDP.
From Bank of America they have prepared a report to discuss the situation of these firms. “We have found that while a severe credit crunch is not priced in for small caps, a mild recession is. And after narrow market leadership, we see short-term recovery potential in areas including the S&P 500, higher yielding bonds, and high yield bonds.
However, the entity sees numerous risks in the medium term for small caps, which suggests “the need to be agile”. Despite the rally, his sense is that positioning for these types of firms remains low: Bank of America clients have continued to trade small-cap stocks in recent weeks with annualized record outflows so far this year. In addition, market commentary from the shorting research team suggests that much of the recent rally in the Russell 2000 is due to short covering.
“Funds remain underweight small cap stocks, although technical data has improved… And the S&P 500 is officially in a bull market (up more than 20% from the October lows), where, from the In the 1930s, the selective and Russell have normally bottomed out within a month of each other (which suggests that September was the minimum for Russell)”, analyzed the bank. In this way, it would be necessary to continue observing near the following movements in the chart to make a cautious decision.
Both the Russell 2000 and the S&P 600 have risks, from the point of view of the entity’s team of analysts. “We have highlighted the low quality risk of the Russell 2000… But, conversely, as many non-profit stocks have less debt (for example, many stocks in the technology and healthcare sectors), the leverage metrics look worse for the S&P 600, which also has higher rollover risk, he explains.
The bank says it continues to favor stock selection over indexing, also supported by high dispersion within valuations, better amplitude of small bearish drives, and evidence of investor interest in individual stocks vs. ETFs to date.
Monetary policy tightens the rope
Elsewhere, Bank of America now anticipates two more Fed hikes in July/September, with the first rate cut in May 2024. “Higher cost of capital and further credit crunch pose risk to credit companies.” lower capitalization, with an increase in refinancing risks in 2025”, they comment. Regional banks (8% of Russell 2000) may remain under pressure, and regulation could affect multiples. “At the sector level, we view financials, technology and healthcare as especially threatened in small-caps compared to large-caps,” she says.
Small-caps posted strong first-quarter earnings growth, but while forecasts have improved, they remain weaker than large-caps. “Seasonality also tends to be weak for small caps in late summer/early fall (…) entity .