The stock market has not responded well to indications that the U.S.–China trade dispute is falling off course. I’ve written many times that Fed policy, corporate earnings, and the China trade deal would be three key drivers of market returns in 2019, and it follows that bad news on any of those three fronts is likely to make the market wobbly.

But as investors shed risk assets in light of new tariffs and the possibility of a trade impasse, small-cap stocks have quietly been in a flattish, even slightly negative trend over the past year. Without much fanfare at all, small-caps (as measured by the Russell 2000) in late March of this year were still down more than -10% from all-time highs reached in August of 2018.[1] At the same time, the S&P 500 was just a few days away from reaching a new all-time high.


So, what’s been keeping pressure on small-caps?

To understand the answer, one must first understand how small-caps tend to behave in general. Small-cap companies are, generally speaking, domestically-based with fairly low international exposure. They’re also companies with higher risk/reward characteristics, since they (again, generally speaking) have the ability to post faster growth rates than a huge, multinational corporation. That being said, small-caps also tend to hold more debt relative to cash and revenues, and they’re highly sensitive to growth in the broader economy.

Readers might catch two takeaways here:

1) If small-caps tend to be domestic companies with less exposure to foreign countries, wouldn’t a trade war with China help boost domestic sales?
2) If we’re really in the late innings of this economic expansion, are investors maybe pivoting to larger cap companies with more stable earnings, lower debt, and more cash?

While I think both takeaways are true statements, I think it’s the second one that matters more. And that’s arguably what’s holding small-caps back today.

If you take a look again at the chart above, you’ll notice that small-caps reached a higher all-time high than the S&P 500, but also endured a larger correction during the Q4 sell-off. In my view, such a pattern is totally normal, with small-caps experiencing bigger swings and higher levels of volatility than large-cap stocks. Par for the course.

But keen observers might notice a slight shift in the pattern, beginning in March. When we think of the broad market in Q1 and even through April, we tend to think of it in terms of the strong rally off the bottom. And while small-caps did experience a strong bounce in January and February, you’ll notice that from the beginning of March through today that small-caps have struggled to push higher, instead tracking sideways and even slightly negative. This may be a signal that investors are increasingly determined to favor larger cap companies as the economic growth picture softens with time.

Bottom Line for Investors

Does this mean it’s time to remove small-cap exposure from portfolios? I would say no. For one, small-caps could very well defy the recent trend and shoot higher in the next few quarters. After all, our base case is still for growth in the U.S. economy and the world, even if we expect it to be modest.

Secondly, for investors who have investment objectives that make it suitable to own small-cap stocks, they can be a valuable piece of a diversified portfolio. Since the market low in March 2009, you can see that small-caps have been just as valuable – if not more valuable – to investors with a diversified approach.

Source: J.P. Morgan[2]

I would argue that instead of trying to time when to favor small-caps versus mid-caps versus large-caps, building a diversified equity portfolio with exposure to each category can produce the desired results with more control for risk.

Disclosure

1 CNBC, May 9, 2019. https://www.cnbc.com/2019/05/09/small-caps-fall-into-into-correction-down-10percent-from-highs.html
2 This illustrates market returns of the S & P 500 index. All calculations are cumulative total return. J.P. Morgan, April 30, 2019, https://am.jpmorgan.com/us/en/asset-management/gim/adv/insights/guide-to-the-markets/viewer

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