Small cap stocks fail to join in US stock market party

“Small cap stocks are often seen as a good barometer for economic activity in their region, as they are less well developed and thus likely to be more reliant on their domestic market. It may therefore be of some concern that small cap indices in the US, Europe and UK are all failing to make marked headway, even as equity markets look forward to cooler inflation, a soft landing and interest rate cuts,” says AJ Bell investment director Russ Mould.

“Any fresh upward momentum in small cap stocks on either side of the Atlantic could therefore be a positive sign. But the current weakness throws into even greater relief, from a US and a global perspective, the role of the Magnificent Seven of Alphabet, Amazon, Apple, Meta, Microsoft, NVIDIA and Tesla, all of whom bask in the glow of the market’s current enthusiasm for artificial intelligence (AI), to one degree or another.

“Small caps are more likely to be attuned to local economic events rather than global ones: they are younger in their development, so will have less breadth in terms of product, less depth in terms of management and less reach in terms of geography.

“One example of sluggish small caps can be seen in the UK, where both economic performance and the returns from its leading stock market indices continue to attract plenty of brickbats.

“The economy looks to be stagnating, if the Office for National Statistics’ numbers are anything like a reliable guide. Four consecutive quarters of year-on-year growth below 1% does not inspire confidence.

Source: Office for National Statistics

“Meanwhile, the FTSE 100 is just 7% higher than it was at the turn of the last century, after twenty-three years of huffing and puffing. (The total return of 159% is a little more like it, but even that equates to a compound annual growth rate of just 4%).

“It is possible to accentuate the positive. Since 31 December 1999, the FTSE Small Cap has put up a much better show, as it has doubled in value.

“But even here the sceptics have been handed ammunition, as this benchmark had made almost no progress at all over the past five years. The FTSE Small Cap’s index is broadly consistent with the trajectory of the UK economy – a slump in 2020, when covid-19 and lockdowns hit output hard; a dramatic recovery as the government and Bank of England liberally applied fiscal and monetary stimulus; and then a gradual return to trend as the bills for that ‘free’ money appeared in the form of higher taxes, higher interest rates and higher input costs (inflation).

Source: LSEG Datastream data

“The small-cap malaise is not just a UK phenomenon, however. Small cap stocks are making heavy weather of it on a global basis, too.

“This is potentially less good news. Sliding small caps may (just about) fit with the prevailing narrative of a cooling in inflation, a ‘soft’ economic landing and a pivot to interest rate cuts from central banks. But if the gentle slide picks up pace, it may be suggestive of a harder landing. Equity and bond markets may therefore get the rate cuts for which they are baying, but for the ‘wrong’ reason, namely a sharp economic slowdown (or even a ‘hard’ landing).

“The FTSE Global Small Cap index, which comprises 5,873 stocks with an average market capitalisation of $1.3 billion, is down by 14% from its autumn 2021 peak. Industrials and technology are the two largest sectors by weighting, at 16% and 13% respectively.

Source: LSEG Datastream data

“The global benchmark has a 61% weighting toward the USA and investors could be forgiven for thinking this should help. It clearly is not and that may raise some questions over the health of the US economy, too.

“The official GDP numbers, powered largely as they are by federal government spending, look good, but perhaps the foundations are not as strong as they seem. The inability of America’s main small cap index, the Russell 2000, to challenge former highs is a potential concern and the index is actually down by 19% from its 2021 zenith, to leave it technically hovering on the cusp of a bear market.

Source: LSEG Datastream data

“Small cap weakness in the USA does not sit well alongside the robust-looking GDP growth numbers, so there may be other factors at work.

“One may be the Russell 2000’s mix. It is estimated that up to 40% of its constituents are loss-making, compared to around 15% in the 1990s. That mix may not be suited to a time of rising interest rates, especially as small cap companies will not have the sophisticated treasury departments of the big caps, so they may now have locked in new borrowings and sources of cheap funding when they were freely available during the pandemic, thanks to interest rate cuts, low bond yields and Quantitative Easing.

“However, investors with long memories could be forgiven for feeling a little uneasy when confronted with such strong performance from mega caps such as the Magnificent Seven, which now combine to provide 30% of America’s $40 trillion stock market capitalisation on their own, and weakness from small caps.

“Similarly bifurcated markets were evident in 1967-68 (when technology and growth stocks were all the rage), 1970-73 (the ‘Nifty Fifty’) and 1998-2000 (technology, media and telecoms companies). All three booms ended with busts, and with all of the gains in the headline indices wiped away.

“It was possible to make good money on each occasion, none of which were a flash in the pan. But no-one rang a bell when it was time to get out and anyone who just held on finally had to give best to the market’s Cassandras.”