A resurgence in the dollar potentially bodes well for one group that has struggled to reclaim record territory after last year’s rout: small-cap stocks.
The Russell 2000 index (.RUT) of small-capitalization stocks remains 8.2% below its August record, while larger peers have recently topped their all-time highs following a bruising fourth-quarter selloff. The S&P 500 (.SPX) and Nasdaq (NDAQ) both tallied new records on Monday, while the Dow Jones Industrial Average (.DJI) sits 1% away from its October closing high.
But a recent bounce in the U.S. dollar and tepid inflation could help boost small-cap stocks, which are more tied to the domestic economy than their larger counterparts. Meanwhile, Federal Reserve officials are widely expected to leave interest rates unchanged at their meeting this week, which could help small companies. As interest rates climb, so do the cost of the loans small businesses carry.
Inflation has remained below the Fed’s 2% target, easing fears of an overheating economy for now. That likely means policy makers will be less likely to lift borrowing costs.
Small-caps, which typically have a market value of about $2 billion or less, are at an important juncture. The Russell 2000, which has climbed 19% this year, rebounded in early 2019 but has struggled to stay above 1600, a key resistance level. How small-cap stocks perform in the near term could be a telling sign for the trajectory of the broader market this year, some analysts said.
“A stronger dollar and a Fed on pause should point to a better Russell 2000, but we haven’t seen it yet,” said Carlos Dominguez, president and chief investment officer at Miami-based Element Pointe Advisors. He said the firm would add exposure to small-cap companies if small-caps broke out from their current levels. “You have to watch the Russell 2000 to gauge where the broader stock market goes from here. If small-cap stocks can break out from here, I’ll be bullish.”
Eric Marshall, portfolio manager of the Hodges Fund, which includes both large and small companies, said the firm has bought small-cap stocks this month across a broad array of sectors including financials, consumer discretionary, technology and health care. He is also a portfolio manager for the Hodges Small Cap Fund.
“We do think you can find opportunities in small-caps, in particular some of the beaten-down financial stocks, technology in both software and semiconductors, as well as some of the more cyclical areas like home-building,” Mr. Marshall said.
Fears of slowing economic growth and higher rates dented the appeal of small-caps at the end of last year. Smaller companies tend to struggle for traction at the end of economic expansions due in part to rising wages and borrowing costs.
A recent bounce in the dollar has made some analysts more optimistic. Small-caps are more insulated from a stronger dollar than larger companies because their revenues are more likely to come from inside the U.S. while larger multinationals’ have more exposure overseas, making foreign revenues smaller when converted back to dollars.
The dollar climbed to its highest level of the year last week, boosted by better-than-expected economic data. The WSJ Dollar Index, which gauges the U.S. currency against a basket of 16 others, hit its highest level of the year last week. The dollar slipped 0.1% Monday to 90.81. Since the dollar first hit a fresh 2019 high on April 23, the Russell 2000 has climbed 2.5%.
To be sure, small-cap stocks still look pricey to some investors. The Russell 2000 trades at 35.6 times projected earnings over the next 12 months, higher than its 10-year average of 29.7, according to FactSet. The S&P 500, meanwhile, is trading at 19.2 times projected earnings, up from its 10-year average of 17.6.
One corner in small-caps that looks attractive from a valuation perspective is financials, the largest weighted group in the Russell 2000, which was among the battered groups in the fourth-quarter selloff. The financial-services group in the Russell 2000 trades at 19.7 times expected earnings over the next 12 months, up from 16.5 times at the end of last year but down from 24.6 at the end of 2017, FactSet data showed.
“I’m more positive on financials on the smaller side than the bigger firms,” said Susan Schmidt, head of U.S. equities and portfolio manager at Aviva Investors, who is also encouraging clients to add exposure to small-cap financial stocks. “It’s easier to grow when you’re smaller. Investors have written off banks because they feel that all of the tailwinds have passed. But with the economy in good shape, there’s still growth opportunities for them.”
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