Why Small Cap ETFs Poised To Pop

July 12, 2019

U.S. small cap ETFs have delivered a good run in 2019, but on a relative basis, they continue to underperform large caps this year even as the market makes new highs. This could be about to change, some say.

The recent relative weakness in small caps really kicked off in the last quarter of 2018 when the market took a downturn. Small-cap stocks are very sensitive to the domestic growth story, and concerns of a slowdown in the U.S. economy really took hold late last year, weighing on the segment.

The iShares Russell 2000 ETF (IWM) ended 2018 down 11%, tallying double the losses the large cap iShares Core S&P 500 ETF (IVV) saw last year. Year to date, IWM has recovered nicely, rallying 17%, but it’s still lagging IVV by about3%.

 

 

Eve Of A Rally?

In a recent blog, Anu Ganti, director of index investment strategy at S&P Dow Jones Indices, noted that tilting toward small caps has been a drag to overall equity returns, whether you are a broad stock investor or a factor-focused one. Betting on small size hasn’t really paid off relative to large caps.

It’s not surprising to see small cap ETFs lag large cap funds at this stage in the cycle. Smaller companies tend to do better in the early days of a cycle when growth expectations are at their highest.

Some, however, now say we could be at the eve of small cap ETFs’ next big pop.

Why? Because a more dovish Federal Reserve and possible interest rate cuts as early as this month could spark the next leg up of economic growth—the very scenario that would push small cap stocks higher.

“There’s a reversion to the mean argument, and small caps are usually hit hardest by market expectations,” said Sal Bruno, chief investment officer of ETF issuer IndexIQ. “Rate cuts by themselves are great for large cap stocks, as is a weakening dollar, but if economic growth starts to take hold and we see a steepening of the yield curve, small caps are big beneficiaries.”

Looking For A Catalyst

On paper, small caps are looking cheap, near historical lows relative to large caps, according to Ron Saba, senior portfolio manager at Horizon Investments, “so cheap they’re easy to neglect.”

Saba, who’s been a long-term small cap value investor, says investors are finding more attractive returns by buying mega cap stocks this year, technology names. They’ve had little reason to take a closer look at small cap ETFs.

But consider that the forward price-to-earnings (P/E) ratio of the Russell 2000 relative to the S&P 500 is close to its lowest level in 10 years, Saba says. The Russell 2000 forward P/E is about 20x and the S&P 500 is around 16x next year’s earnings.

Valuation Argument

According to Horizons’ data, small caps typically trade at 50-60% P/E premium on forward earnings to S&P 500 in a range that can go as high as 80%. Right now, we are at about 40% premium, on average.

“Small caps look interesting from a valuation standpoint; we just need some catalyst to turn sentiment around,” Saba said.

The market has already priced a rate cut later this month, but crucial for the small cap segment will be what happens next. Does the Fed remain supportive, and does the market believe in it enough to turn around the growth story?

“Second quarter earnings announcements are coming out soon, and expectations are for lower earnings and GDP [gross domestic product],” Saba noted. “If there’s any surprise to the upside, and we get better earnings in small caps relative to S&P 500—which will happen if we get a risk-on environment—it could be a double whammy.”

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