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- Following the 1H 2022 selloff, the Russell 2000 never regained the mojo that has powered the larger-cap S&P 500 (SPX) and NASDAQ 100 (NDX) to near record rallies.
- RTY trades as if investors expect a recession – even though those fears faded over a year ago.
- Rather than recession concerns, RTY has been weighed down by fundamentals: small-cap earnings have been weaker than SPX/NDX, and RTY has a larger concentration of rate-sensitive banks and real estate companies than SPX.
- With a soft landing ever more likely, we expect fundamentals to gradually improve for small caps.
- We like overweighting RTY on expectations it can outperform SPX in 2024 – although we stress this will be a patient trade.
Since the selloff of 1H 2022, the S&P 500 (SPX) and NASDAQ 100 (NDX) have posted impressive rallies in 2023. But the Russell 2000 (RTY) has missed the party (Chart 1).
This is unusual. Outside highly stressed markets, RTY usually tracks SPX closely.
Specifically, RTY underperformed versus SPX during the recessions of 1991, 2008-09 and 2020 but soon roared back (Chart 2). The late 1990s also saw lasting underwater performance, but that was due to the dot-com bubble years. RTY did not so much recover as the SPX returned to earth when the bubble burst.
Now, RTY performance vis-à-vis SPX is at the recession levels of 1991 and 2020, even though recession fears faded by 3Q 2022. We highlight several reasons – and no, it has little to do with positioning for a recession.
Over the past 35 years, RTY earnings have tended to match or modestly outpace SPX. That explains the near decade-long outperformance after the financial crisis. The exceptions were during recessions, when RTY earnings simply collapsed. That is why RTY underperformed in 1991, 2008, and 2020. But earnings soon recovered, as did RTY.
Over the past 1.5 years, earnings for SPX and NDX flatlined after growing rapidly in the quarters after the 2020 election. But RTY earnings fell 16% in early 2023, and earnings growth over the next year appears likely to lag SPX.
Indeed, the RTY P/E ratio has stayed in a normal range around 23-25, strongly suggesting investors have been pricing in the earnings outlook rather than a recession scenario.
Loss-Making Companies Have Been a Drag
Another indicator we track is earnings per share (EPS) for the RTY index versus EPS for companies with positive earnings. When the economy is growing, the ratio of positive EPS to total EPS tends to be 1.25-1.50, but it rises above 2 during periods of stress due to a larger number of loss-making companies. (This ratio is usually near 1 for the SPX index, as large companies rarely report losses, especially on a trailing 12-month basis.)
That ratio has risen steadily since mid-2022 and is about 2 now. Clearly, a combination of supply-chain problems, labour shortages and rising costs have pressured many small-cap companies. Most of these companies operate in highly competitive environments. They lack the pricing power that SPX companies have exhibited, many of which enjoy quasi-oligopolies in their sectors.
RTY Is More Interest-Sensitive Than SPX
The most interest-sensitive sectors this year have been banks and real estate – both have relatively large representation in RTY. Banks comprise 8.1% of RTY, versus 2.8% for SPX. The real estate sector, which is mostly REITS, is 5.6% of RTY, versus 2.8% for SPX.
In the rising rate environment of recent months, this exposure has penalized RTY. The flipside is any substantial rally in Treasuries should benefit RTY. And that is what happened when Treasuries rallied after the soft October jobs reports. But RTY and KRE relinquished most of those gains, while SPX kept rising on lingering concerns about banks as Treasuries stabilised. Then there was another sharp rally in Treasuries and equities after the mild CPI report.
More broadly, RTY has shadowed KRE since the selloff when Silicon Valley National Bank failed in March, albeit with considerably less volatility given its more limited exposure to banks.
We are constructive on regional banks. The recent round of earnings revealed few signs of weakness in loan portfolios, or deposits, and most banks posted better than expected net interest margins. In short, there was little to fan concerns about more regional bank failures. Instead, the big concern was if rates rose, net interest margins and earnings would come under pressure in coming quarters. In other words, investor concerns shifted from credit quality to earnings.
We acknowledge that a recovery in regional banks will be gradual. It will take a combination of lower rates and clarity on the regulatory consequences of the cascading bank failures of 2023. That will weigh on RTY.
RTY Is a Patient Hold
We think RTY is at or near the low relative to SPX. We expect RTY will recover going forward, although this is likely to be a gradual process.
We look for earnings to improve as lingering supply chain issues (which disproportionately affect smaller companies) normalize and inflation cools. The prospect of a soft landing in 2024 should also improve the earnings outlook.
We have already seen twice now since the beginning of November how the salubrious effect of lower rates may disproportionately favour RTY. Inflation may be slow to return to the Fed’s 2% target, but even further modest improvements should spur further rate declines and RTY rallies. Lastly, as noted above, as investor concerns about more bank failures ease, bank equities will recover.
We like overweighting RTY – but we stress that this will be a patient trade.
The risk in this trade is that the economy slows sharply and unemployment rises. This scenario will most likely lead to another collapse in earnings and decline in RTY.
 Other banks that failed around the time of Silicon Valley National Bank were Signature Bank and Silvergate Bank. First Republic Bank limped along until early May when it was acquired by JP Morgan Chase.
Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.