Smaller companies in the US could outperform large caps by 10% or more over the next 6 months

No matter how one looks at it, whether through the lens of America’s most successful 500, 2000 or 5000 public listed companies, one may be forgiven if you thought solely based on stock price movements alone, the economic damage from COVID-19 is long forgotten. With the fastest bear market in history – from mid Feb to late Mar – we also saw one of the fastest market recovery to date. As of May 1^st, the S&P 500 index is only a mere 14% off its highs.

Among the various market segments, the S&P 500 Index (which is dominated by technology and healthcare companies) fared much better in terms of maximum drawdowns and recovery from trough than the small and mid cap segments of the US equity market. As seen, the damage done to companies of various sizes appears to be unequal. The constituents of the S&P 500 Index today is biased towards technology and health care, both forming about 41% of the index, and these companies either have low debt and high cash flows (technology), or they tend to have more defensive earnings (health care).

Chart 1: Various US market segments performance year-to-date (indexed to 100). Small and mid-caps have underperformed its larger peers

Where is the economy going next? We can try to infer what Mr. Market (market participants on aggregate) is thinking by understanding the intermarket dynamics across equities and fixed income markets. Are investors bearish or bullish? What are the current growth and inflation expectations of investors? Can we draw conclusions from our observations, and from there, figure out the types of opportunities to capitalise on?

What the intermarket dynamics are suggesting

1. The equity market is recovering from extremes in bearish sentiment. Investors are often handsomely rewarded for taking a position in equities during such periods when sentiment is poor.

Looking at how traditional defensive sectors are valued relative to the broad equity market is one way to understand how market participants perceive market risks. When the market caps of defensive sectors (e.g. consumer staples and utilities) relative to the broad equity market increase, market sentiment can be interpreted as poor or risk-off, and vice versa. Studying how these ratios change over time is probably one of the many ways to understand market sentiment, aside from investor surveys and et cetera.

Chart 2: Significant upside in equities tend to follow after periods of extremes in negative sentiment

We can use a simple average of the Consumer Staples / Equities ratio and Utilities / Equities ratio to understand investor positioning. According to the chart above, extremes in negative sentiment (as denoted by the -2 standard deviation mark) are uncommon, and when it happens, it suggests there is high probability of significant upside in equity markets in the months ahead. The dotted lines highlight extreme points in pessimism which tend to coincide with major lows, if we assume that the current 10-year equity bull market is not yet over.

2. Markets are pricing in inflationary expectations in light of a gradual reopening of the US economy. Small caps could outperform over the coming months.

Inflation expectations can be inferred from a difference between a treasury bond ETF (NYSE: IEF) and inflation protected treasury bond ETF (NYSE: SPIP) as they have similar duration profiles. As seen from the chart above, the value of inflation protected treasuries relative to 7-10 year treasuries saw a new low since the GFC. Small caps’ performance, relative to their large cap peers, also saw a nose dive. We note that small caps’ performance often correlate well with inflation expectations since they tend to be more cyclical and domestically oriented when it comes to earnings. The fact that the ratio of inflation protected treasuries have rebounded strongly in relative terms give us reasons to believe that inflation expectations have bottomed.

Chart 3: Small caps historically outperforms large caps in the following months after inflation expectations bottom and recover

This notion is also supported by the evolution of the US treasury yield curve over the past three months. From these changes, we gather that inflation expectations and risk sentiment have largely been reset (see Chart 4).   A rising yield curve occurs when the market expects the economy to grow down the road, and higher prices is a prerequisite for rising stock prices over the long term. For equities, a rising yield curve a good sign that investors are no longer as pessimistic as before, as they demand a risk premium for holding long dated assets to compensate for potentially higher inflation and consumer prices in the future.

Chart 4: US’s yield curve is no longer ‘inverted’

Odds are often in one’s favour when an overweight position is taken in smaller caps over large caps when inflation expectations have bottomed. Furthermore, small and mid-caps have underperformed significantly year-to-date, and we believe that any sustained broad market recovery will likely see the underperforming segment play catch up with its larger peers. A simple reversion to the mean of small caps’ market cap relative to large caps would suggest a relative outperformance of 10% or more (from current 0.45 to long term average of 0.5, see Chart 3) as long as sentiment and inflation expectations continue holding up in the months ahead. While the spreads in the yield curve is small given the absolutely low yield environment we are in, the rising steepness of the yield curve provides the basis for a recovery in growth prospects in the quarters ahead.

According to market participants, reflation is the base case for now

Fundamentally, reflation is perhaps the biggest reason why equity markets have rebounded so quickly. Whether reflation will play out for sure is uncertain, however, what we know is that it is what market participants are likely expecting at the moment. Even though much of the US is still closed, and are slated for gradual reopening in phases, markets are expecting the potent mix of stimulus cheques and unlimited quantitative easing programs to be inflationary in the near future. Furthermore, at the latest FOMC meeting, the Federal Reserve has reiterated that low interest rates will likely be here to stay over the medium term, which would be conducive for the US to orchestrate an economic revival.

While disconnect between equity prices and current economic fundamentals grows wider, the rebound suggests that investors are more than happy to take on equity risks in an environment where the ‘Fed put’ (the notion that the US central bank will shore up assets at first signs of trouble) is all but assured. Market participants, however, cannot be said to be acting irrationally. With so much cash and pent up demand on the sidelines, investing in equities at this point when current financial risks are perceived to be lower than before, is a logical response if one expects higher economic activities after the US economy reopens, which may lead to potentially higher consumer prices in the future.

Seize upside opportunity with US small caps

O’Shaughnessy Asset Management also offers a different perspective in how there is a very attractive opportunity in US small caps now.  They noted that forward returns for small caps after bear markets tend to be very strong and often outperforms their larger peers.

Source: O’Shaughnessy Asset Management

Data as of 30 April 2020

As seen from Chart 1, year-to-date performance wise, small and mid-sized companies have been laggards. We think that this segment of the US equity market could outperform over the next three to six months especially if the broad US equity market maintains its positive momentum over the coming months. Should that play out, US small caps could potentially provide an outperformance of 10% or more over their larger cap peers.

To take advantage of this upside opportunity, we recommend investors to tactically allocate a portion of their US exposure towards small caps, if you haven't done so. This can be done indirectly via a US focused fund like the FTIF – Franklin US Opportunities, a multi-cap US equity fund, or directly via the numerous US small cap funds available on our platform. The latter would give you more flexibility and control over the level of exposure towards small caps, but the FTIF fund would be more suitable for investors who are less familiar with what to do.

Year-to-date, smaller companies with quality and growth tilts have outperformed cyclical value, as seen from the performance disparities amongst the US small cap funds available on our platform. Growth-centric funds like JPMorgan Funds - US Small Cap Growth A (dist) USD and Neuberger Berman US Small Cap A Acc USD are some of our platform’s best performing funds thus far. While growth has led value so far, investors may want to also consider taking on a blended approach (mix of value + growth) in expressing this tactical idea. Hence investors may also consider funds such as Blackrock US Small and MidCap Opportunities A2 USD or Legg Mason Royce - US Small Cap Opportunity A Acc SGD-H.

Source: iFAST Chart Centre

Data as of 30 April 2020