What’s behind the extinction of US small caps?

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By Mark Barnes, Ph.D., Head of Investment Research (Americas), and Christine Haggerty, Research and Analytics

A year ago, US small-cap stocks rode the post-lockdown jubilation fueled by news of a Covid-19 vaccine breakthrough. In January, US small caps led the global stock market crash, even approaching bear market territory at one point during the month.

While US large caps have also struggled lately, they have fared much better than their smaller counterparts: the Russell 1000 fell 5.6% in January compared to a 9.6% decline for the Russell 2000. For the 12 months to last month, the Russell 1000 climbed 20.3%, while the US small cap index was down 1.2%.

So what’s behind this small cap underperformance? The fall in both indexes over the past few months has coincided with the hawkish shift in policy by the Fed, which has become even more aggressive in the new year as the US economy continues to run at full speed. But while this environment has favored sectors sensitive to the cycle (and attractive valuations), investors show a clear preference for the big players in these sectors.

US Russell Indices Total Returns (%)

US Russell Indices Total Returns (%)

FTSE Russell

Data through February 4, 2022. Past performance is not indicative of future results. Please see the end for important information.

Big tech, banks and pharma prevail

Analyzing the data, we find that differences in industry composition and behavior within industries explain much of the 12-month performance gap between the two indexes. Much of the Russell 1000’s outperformance over the past year has come from its greater exposure to the technology and consumer discretionary sectors, which are dominated by long-time popular heavyweights like Apple (AAPL ), Microsoft (MSFT), Alphabet (GOOG) (GOOGL), Nvidia (NVDA), and Amazon (AMZN). The two industries make up 46% of the large cap index, compared to 28% of the Russell 2000.

These stocks propelled the large-cap index higher last spring and summer, as a fresh wave of Covid-19 cases and a spike in inflation dashed recovery hopes and US bond yields have fallen. Although mega-cap tech stocks have borne the brunt of this year’s market rout and the sharp rise in US bond yields, software stocks still top the Russell 1000 performance list for the period. 12 months ending in January, contributing almost a fifth of the total. returns, as shown in the graph below.

As we’ve explained in a previous article, the start of the Fed’s tightening regime is a major headwind for high-priced tech and other pandemic-era highflyers, as rising rates diminish value. market for future earnings growth.

The 10 best and worst contributors to index returns over the 12 months to January 31, 2022

The 10 best and worst contributors to index returns over the 12 months to January 31, 2022

FTSE Russell

Based on Industry Classification Benchmark (ICB) data as of January 31, 2022. Past performance is not indicative of future results. Please see the end for important legal information.

Contributions from large banks and insurers have also significantly outpaced their small-cap peers in recent months and for the 12-month period, although financials make up 16% of the Russell 2000, six percentage points higher. than in the Russell 1000. Large-cap pharmaceutical and biotech stocks also beat their smaller counterparts, although the healthcare sector makes up 17% of the latter index, four points higher than in the large-cap index. capitalizations.

Select Russell 1000 Sector Returns vs. Russell 2000 Sector Returns (TR, Rebased)

Select Russell 1000 Sector Returns vs. Russell 2000 Sector Returns (TR, Rebased)

FTSE Russell

Based on Industry Classification Benchmark (ICB) data through January 31, 2022. Past performance is not indicative of future results. Please see the end for important legal information.

Persistent macro stress favors the big over the small

Recent contribution patterns show not only a strong bias towards recipients of a stronger US economy, but also big players in these industries. These businesses typically benefit from greater economies of scale, more diversified revenue streams, and better access to capital, which should help them navigate Covid-related supply and labor chain disruptions and a period of rising interest rates more effectively than their smaller cohorts. The small cap index is also potentially facing greater headwinds as the pace of the US economic recovery from the crisis normalizes.

As the Fed tightening cycle continues, fiscal stimulus fades and Covid-19 remains a major overhang for the US economy, the relative performance of US large and small cap indices will likely continue to depend important fundamental and competitive differences between large and small caps. small businesses and their effectiveness in overcoming these persistent macroeconomic stress points.

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Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.

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