Small Cap Rout Is Flashing Red Flag For US Economy

The post-election small cap bounce in US stocks has now been completely erased as it seems tax-reforms have now been entirely priced-out of markets. However, as BofAML notes, the demise of small cap stocks relative to the broad market augurs badly for forward-looking economic growth...

The Russell 2000 is now the worst performing major index this year, up just 1% YTD...


Via BofAML,

After outperforming large caps by over 10ppt in the one month following the US election, small caps have all but wiped out that outperformance over the subsequent eight months.

And while we remain bearish on small caps, and see far more reasons to be cautious, we view tax reform as the biggest risk to our bearish outlook now that it has essentially been priced out of the market.

Small cap earnings growth continues to lag


Small cap earnings growth has lagged that of large caps in each of the past four years, and that streak appears on track to continue, at least for the first half of 2017.



As earnings season draws to an end, small caps are on track to post negative 2Q profit growth (-8%) compared to positive growth for mid (+7%) and large (+9%). Earnings growth for large caps has been boosted by the weaker dollar and improving global growth, neither of which has benefited the small caps. In fact, earnings growth is broadly negative within small caps, with just four sectors posting positive growth. And even though July saw the small cap three-month earnings revision ratio (ERR) improve for the fourth consecutive month to its highest level in a year, large cap trends have been improving faster, with the gap between large and small cap revision ratios at multi-year highs.


The four horsemen are on the move


Among the growing number of late-cycle signposts is small cap factor performance. So far this year, the four factor groups with positive return spreads (Liquidity, Low Leverage, Growth and Momentum) are the same four groups that have outperformed at the end of each of the last three bull market cycles. Similarly, the worst-performing factor group (Valuation) so far this year is the only group that has underperformed during each of those periods


Small caps just say no to inflation


While the historical relationship between small caps' relative performance and inflation has been mixed, there has actually been a strong relationship between small cap valuations and inflation. In fact, the correlation between the Russell 2000 forward P/E and core CPI growth since 1978 is -84%, and based on this relationship, the current P/E of 18.6x suggests that small caps are discounting core inflation of 1.6%, modestly below the latest reading of 1.7%. If core inflation were to eventually rise to just 2%, history would suggest 13% downside to small cap valuations and 24% downside if inflation were to rise to 3%.


Still plenty of headwinds for small caps


Until recently, small caps have been benefitting from low volatility, improving growth, and tightening credit spreads, but these may be reversing course. Credit spreads are already near the lows of cycle, even as loan delinquencies have started to pick up and the Fed continues to raise interest rates. Small caps have underperformed in four out of the last five Fed tightening cycles and seven of the last nine periods where the ISM manufacturing index was falling.

So to summarize, small caps are almost entirely reliant on US economy for growth unlike mid/large caps which have much greater international exposure.

And this is why it is a huge red flag for the US economy that Small Caps have drastically underperformed mid/large caps for the last six months:

Greater sensitivity to the US economy (Chart 3), partly owing to their lower foreign exposure (Chart 4) position small caps to benefit disproportionately from better domestic economic growth.

But this may be more of a headwind for small caps, as growth in the US continues to lose momentum and the outlook for stimulus has faded.

With tax reform priced out, we see a deal as the biggest upside risk for small caps. But we remain cautious given high valuations, weak fundamentals, record leverage and an unsupportive macro backdrop.

Small caps are particularly sensitive to rising volatility and tightening credit conditions.

Which could be about to become a huge problem as US HY Corporate bond risk spiked 30bps this week - its biggest jump since the election...