Small-cap stocks were among the biggest losers during the stock market’s rout late last year as investors worried about high leverage, but they have outperformed in 2019’s rebounding market, with shares of debt-laden companies leading the charge.
So far this year, the small-cap Russell 2000 index (.RUT) has advanced 12.9 percent, versus a 9-percent gain for the benchmark S&P 500 index (.SPX). Another small-cap index, the S&P 600 (.SML), has gained 12.1 percent.
An expected pause in the Federal Reserve’s course of interest-rate hikes - and optimism that a recession is not imminent in the next 12 months - support a further run in small-caps, investors say. The caveat is that as economic growth and corporate earnings taper off, these companies will find it increasingly difficult to make payments on their borrowings.
The rebound comes after the Russell 2000 and the S&P 600 both hit levels in December that were more than 20 percent below their August peaks, which many investors consider confirmation of a bear market. The S&P 500 bottomed 19.8 percent below its September peak, just missing the bear designation.
Small-cap stocks’ performance typically tracks investor appetite for debt. Though the median debt-to-equity ratio for the S&P 500 is greater than that for the Russell 2000, small-caps are seen as more sensitive to debt concerns because such companies often secure financing through bank loans with adjustable rates rather than fixed-rate bonds.
Last year’s rise in interest rates means more and more highly-indebted companies may have to scramble to make payments. The number of companies struggling with debt obligations is near record highs, according to the Institute of International Finance.
Moreover, of Russell 2000 companies, 38.3 percent have no net income, whereas only 1.4 percent of S&P 500 companies have no net income.
Leading the way up
In December, credit spreads, the difference in yield between corporate securities and U.S. Treasuries, widened by the most in more than seven years for both high-yield and investment-grade corporate bonds, according to ICE BofAML index data.
But as credit spreads have narrowed, a sign investors are less risk-averse, small-cap stocks have climbed. They got a further reprieve last Wednesday when Federal Reserve policymakers signaled a pause in its tightening cycle.
“With still-low interest rates and an environment of still-solid growth, the concerns about how many (companies) will default are just pushed off to the next slowdown in the cycle, which we don’t see happening anytime soon,” said Kate Warne, investment strategist at Edward Jones in St. Louis.
Highly leveraged companies led the way down in late 2018 and have led the way higher this year.
In the fourth quarter, the Russell 2000 companies whose shares were in the highest quartile of percentage declines had a median debt-to-equity ratio of 41.1 percent. By contrast, Russell 2000 companies whose shares were in the lowest quartile of percentage declines had a median debt-to-equity ratio of 32.3 percent, according to a Reuters analysis.
However, in January, the first group gained 16.6 percent on average, while the second group gained just 4.7 percent.
“They’ve dropped so much that they’ve become an area of interest to screen,” said Scott Hood, chief executive at First Wilshire Securities Management in Pasadena, California, of highly-leveraged small caps.
Debt concerns linger
Yet concerns about leverage have not entirely abated as economists and market watchers anticipate the end of the current economic cycle in the next few years.
At last week’s news conference, Federal Reserve Chairman Jerome Powell said that the U.S. central bank was monitoring corporate debt levels.
At the recent World Economic Forum in Davos, Switzerland, International Monetary Fund First Deputy Managing Director David Lipton pointed to corporate debt as an economic risk.
“There’s going to be a big focus this year by companies in general, but also small caps, to de-lever as much as they possibly can before the economy deteriorates,” said Kristina Hooper, chief global market strategist at Invesco in New York.
Even those sanguine on the prospects for small caps, such as Eric Marshall, portfolio manager at Hodges Capital Management in Dallas, say they have focused more intensely on companies’ balance sheets when picking stocks.
Tim Ghriskey, chief investment strategist at Inverness Counsel in New York said the recent run-up in small caps is “simply a dead-cat bounce.”
“The levels of debt for not only small caps but also selective large caps remain an issue,” he said.
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