The U.S. stock market’s biggest gains are once again coming from its smallest companies, but the trend may not last much longer.
Smaller-company stocks such as Allegiant Travel Co. and AK Steel Holding Co. have been soaring since late December and leading the rest of the market, a sharp reversal from much of the winter, when smaller stocks were plunging more than the rest of the market. The Russell 2000 index of small-cap stocks has jumped nearly 19 per cent since Christmas Eve compared with 15 per cent for the big stocks in the S&P 500 large-cap index, although neither has returned to the records they set late last year.
Bed Bath and Beyond Inc., for example, has surged 44 per cent since Christmas Eve, helped by a stronger-than-expected earnings report where it said it’s ahead of plan in eventually returning to profit growth. Besides earnings reports, smaller stocks have also been benefiting in recent weeks from reduced worries that the Federal Reserve will raise interest rates too quickly.
The U.S. Federal Reserve has pledged to be patient in raising interest rates, even though the economy is still growing, with inflation low and worries high about weakening growth. That’s a big deal for investors in small-company stocks, because they often carry higher levels of debt than their bigger rivals, which gets more expensive as borrowing costs rise.
Stocks in the S&P 600 small-cap index have about 3.3 times more in net debt than they do in earnings before interest payments, taxes and other items. The big stocks in the S&P 500, meanwhile, have just 1.7 times more debt than earnings before interest payments, taxes and other items.
Just don’t count on this run to last forever.
“We love the bounce back, but we don’t anticipate the momentum continuing,” Jefferies strategist Steven DeSanctis wrote in a recent report. He is sticking with his forecast for the Russell 2000 index of small-cap stocks to end the year at 1,550, which would be just a 3-per-cent rise from Thursday’s close.
After their quick rebound, small-cap stocks no longer look as cheap as they did just a few weeks ago, relative to their earnings.
And if the economy is indeed in the later stages of its current expansion cycle, as many economists believe, smaller companies may be in line for a more difficult time than their larger rivals, for a variety of reasons. Profit margins at smaller companies are more vulnerable to rising costs and a slowing economy, for example, according to strategists at Wells Fargo Investment Institute.
So even though those strategists are forecasting similar returns for small-cap stocks this year as for other areas of the stock market, they say small-cap stocks may take investors on a more volatile ride getting there.