The Spotlight Blog

Does the Worst Ever May for Small Caps Bring a Bounce?

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Thanks to concerns about the potential for the escalating trade war resulting in a global economic slowdown or even a recession, May was not kind to either U.S. Large or Small Cap stocks. It was the worst May for the Russell 1000 Index since 2010, and the worst on record for the Russell 2000 Index dating back to inception in 1979.

Even with this drawdown, Large Caps remain up 10.97% year-to-date, with Small Caps not far behind at 8.65%. Looking ahead, we believe that Large Caps remain more attractive than Small Caps thanks to their higher relative quality and more attractive earnings potential.

What We’ve Seen

  • While investors may have expected Small Caps to provide them with protection compared to Large Caps, the recent intensification of trade talks and threat of tariff increases proved that was not the case last month as the overall deterioration in risk appetite ruled the day.

  • This was expressed through a 21% increase in the spread of U.S. High Yield bonds to U.S. Treasuries over the last month. After peaking on January 3, spreads declined for the better part of the year as credit markets recovered from their slump in December when High Yield issuance effectively froze for the first time since 2008.

Large Caps Outperformed as Spreads Widened

Source: Bloomberg Finance, L.P., FTSE Russell, as of May 31, 2019. Large Cap defined as the Russell 1000 Index, Small Cap defined as the Russell 2000 Index and High Yield Spread defined as the Bloomberg Barclays U.S. Corporate High Yield Average Option Adjusted Spread. Past performance is not indicative of future results. One cannot invest directly in an index.

Money In Motion

  • Driven by outflows from Large Cap ETFs, especially those favored by the trading community as opposed to those used by asset allocators, rolling 1-month flows dropped from the 95 percentile at the end of April to the 2 percentile at the end of May. This sharp turn away from Large Caps over the last month helped to drive down rolling 3-month flows from the 97 percentile to the 58.

  • This investor behavior is reminiscent of January and February 2019; the last time investor preference for Small Caps relative to Large Caps was also as pronounced. Flows among trading and allocation products were mixed during that time period, however, implying that recent outflows are more driven by fast money.

ETF Investors have Moved Sharply Away from Large Caps

Source: Bloomberg Finance, L.P., as of May 31, 2019. Data represents the daily percentile rank over the last 12-months of the rolling 1-month and 3-month net flows of U.S.-listed U.S. Large Cap ETFs and U.S. Small Cap ETFs specifically targeting exposure to U.S. Large Cap and U.S. Small Cap stocks, respectively.

What’s Next?

While the path will be far from a single direction, it remains challenging to find a catalyst for sustained Small Cap outperformance over the coming months thanks to the limited advantages they offer relative to Large Caps amid an increase in the level of economic and market uncertainty, regardless of a further dovish turn by the Federal Reserve.

  • What could provide a boost to Small Caps is simply what they are not; growth-heavy. The Communication Services and Information Technology sectors are each 6% larger in the Russell 1000 than the Russell 2000. Increased regulatory scrutiny appears to be the new normal for Alphabet, Amazon, Apple, and Facebook that, even if it does not lead to breakups, will be an ongoing distraction and likely force investors to assign them a higher risk premium.
  • Even so, while Small Caps have a higher portion (approximately 80%) of their sales coming from domestic sources than Large Caps (approximately 70%), they remain exposed to the trade war due to the integration of supply chains up and down the cap spectrum making Small Caps’ domestic focus less beneficial than simply what the numbers imply.

Small Caps are Underweight Communication Services & Information Technology

Source: FTSE Russell, as of May 31, 2019. Large Cap defined as the Russell 1000 Index and Small Cap defined as the Russell 2000 Index. One cannot invest directly in an index.

Implementation Ideas

  • For investors seeing the May selloff as a buying opportunity, the Direxion Russell Large Over Small ETF [RWLS] allows them to gain increased exposure to Large Cap companies at the expense of Small Caps.
  • Investors who want to position for a near-tern bounce in Small Cap performance, the Direxion Russell Small Over Large Cap ETF [RWSL] offers them a 150% exposure to the companies in the Russell 2000 Index and -50% exposure to firms in the Russell 1000 Index.

 


Definitions

  • Russell 1000® Index: The Russell 1000 Index consists of the largest 1,000 companies in the Russell 3000 Index, which is made up of 3,000 of the largest U.S. companies.
  • Russell 2000® Index:  The Russell 2000 Index is comprised of the smallest 2,000 companies in the Russell 3000 Index, representing approximately 8% of the Russell 3000 total market capitalization.

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