The S&P 500 has been a tough index to beat over the last decade-plus. Just over the past year, the US large-cap index is actually up when you include dividends while foreign shares are down about 12% and US small caps are off a whopping 16%. The Russell 2000 index (IWM) even managed to tag its August 2018 high during the downturn earlier this month. Massive underperformance among the smalls leads many investors to wonder if the group of misfits now represents a good value. Our Weekly Macro Themes report dives into the topic.

A Macro Hopscotch

2022 continues to be the year of the macro. Inflation, Russia, the Fed, and now a legitimate growth scare, each take turns as the primary headline. For US small-cap stocks, the fear de jour is especially important. Consider that the S&P SmallCap 600 (SLY) is comprised more of cyclical companies. Economically-sensitive industries are a perilous place to be should GDP outlooks be revised further lower. Our featured chart underscores that looking under the hood of the market indexes is critical when determining asset allocation.

Featured Chart(s): S&P 500 Large-Cap Index vs S&P 600 Small-Cap Index Super Sector Weight Trends

(Click on image to enlarge)

The above super sector weights don’t come as a shock to most portfolio managers. The Russell 2000 index has a similar cyclical tilt, though there is a slightly higher weight to the growthy biotech industry within the Healthcare sector. For all small-cap investors, though, growing fears of a US recession should warrant a closer look at this popular category.

Shifting Winds

For the last 18 months or so, there have been some macro tailwinds that should have propelled the niche higher vs large caps. Historically, higher interest rates and inflation worked to the smalls’ relative advantage, but that hasn’t been the case. Since November 2020, when the Russell 2000 began to skyrocket, the S&P 500 still outperforms by about 5%. Those tailwinds might be shifting to cyclical headwinds.

Are Small Caps Cheap? Yes and no.

On valuation, the group is “less bad” on an absolute basis and favorable relative to large caps. Moreover, US small caps’ equity risk premium suggests there is some cushion relative to bond yields right now even with the recent jump in rates.

On Profits...

On earnings, while the Q1 reporting season featured a nice beat rate for the group, earnings revisions have come down. EPS growth rates for both full-year 2022 and 2023 are inching lower, too. Clearly, the pandemic’s positive effects on small caps are washing out. And we see that in weak speculative futures positioning and fund flows.

The Bottom Line: US small-cap valuations are lower, but so too are earnings outlooks. While the SmallCap 600 looks cheap vs the S&P 500, absolute valuations are not all that inexpensive. Macro boosts over the last two years appear to be shifting to detractors now that GDP growth turns south - this cyclically exposed area might be particularly at risk.