Weekly Charts
Each Thursday, the MCP Research team will share two charts we’re currently looking at that bring insights into the current state of the markets. This week—small caps.
The recent outperformance in small cap stocks is fueling a strong reopening narrative in the markets. In fact, in February 2021 we tracked the second-largest monthly flow of funds into the iShares Russell 2000 ETF (IWM) since 2012. The narrative is strong, but we think it’s likely it loses steam into the 2nd half of the year. Below are two charts that lead us to believe this.
Figure 1. As 2020 proved, the direction and pace of a move can have a larger impact on investor sentiment than absolute levels. With the pace of reopening slowing, GDP and earnings are going to trend towards lower more normalized growth rates. Although the US economy will continue to improve, these growth rates will peak in Q2 2021. Historically speaking, small cap outperformance has been highly correlated with these moves. As growth rates trend down, we expect small caps to trade accordingly.
Figure 2. It’s also important to recognize how far the growth-to-small rotation has already come. Normally, small-cap stocks trade at higher valuations than their large cap counterparts by a factor of 1.2-1.5x. In Q1 2020, the sharp pullback in earnings estimates caused small cap valuations to rocket higher, pushing this ratio above 2.5x. Vaccine announcements later in the year subsequently pulled these valuations back down as the reopening trade took hold and earnings estimates recovered. Today, this ratio is back within its historically normal range, implying that small cap stocks are fairly valued relative to the rest of the market.
Look for brighter pastures in large cap value stocks, or even in the growth stocks that were dumped to chase the small cap rally.
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