Coronavirus vaccines are finally in sight — and investors are celebrating by scooping up the tiny stocks most likely to benefit from the eventual reopening of the US economy.
Instead, investors are plowing money into the Russell 2000, an index of small-cap stocks whose values are largely linked to the whims of the US economy. The Russell 2000 has spiked 15% so far this month alone.
If it holds, it would be the index’s best monthly gain since 2011 and just shy of its best month since its 1984 launch.
“This move is incredible,” said Ryan Detrick, chief market strategist at LPL Financial. “There is a rush to small caps because they are huge beneficiaries of the economy coming back online next year.”
Not only is the Russell 2000 on the verge of a record-breaking month, but the index also set an all-time high last week. That’s significant because, unlike the flurry of records set recently by the S&P 500, this was the Russell’s first record high since 2018. That suggests there could be more room to run.
“Small-caps literally didn’t go anywhere for two years,” Detrick said. “They were left in the dust. Now they are the ultimate catch-up trade.”
Normally, it takes four or five years for small caps to hit all-time highs after a recession, according to Nicholas Colas, co-founder of DataTrek Research. This time, it took just eight months.
“Hope is absolutely a driver of cyclical stock valuations and returns,” Colas wrote in a note to clients Wednesday. “Traditionally, these hopes recede when the Fed starts to raise rates. We know that won’t be happening any time soon.”
‘Light at the end of the tunnel’
The rotation into small-cap stocks has driven up valuations of these companies. As of Wednesday, the Russell 2000 traded at 31 times forward earnings, according to Refinitiv. That’s well above the 10-year average multiple of 23.
Strategists at UBS Wealth Management told clients this week that smaller stocks are likely to outperform larger ones next year.
“If investing in 2020 was about going resilient, large and American, we think 2021 will be about going cyclical, small and global as the sectors and markets heavily affected by lockdowns start to revive,” the strategists wrote.
Of course, the small-cap gains come at a time of heightened worries about the pandemic. Covid-19 infections are skyrocketing, and hospitalizations around the country are rising sharply.
New York City public schools are shutting down again. Within weeks, the city’s indoor dining and gyms could be closed as well. United Airlines warned Thursday of an uptick in cancellations and deceleration in bookings because of the intensifying pandemic.
Pandemic fears have resurfaced on Wall Street too, with the S&P 500 on track for its third straight day of declines.
“The vaccine is the light at the end of the tunnel,” said Liz Ann Sonders, chief investment strategist at Charles Schwab. “But we’re still in the darkest part of the tunnel.”
Sonders warned that if the economic recovery is pushed further into the future, investors could rush out of small-caps and back into the stay-at-home winners.
Less room for error
Unlike the S&P 500 and the Dow, which are home to multinationals such as Nike, General Electric and Apple, the Russell 2000 is more of a pure play on the US economy.
The median market valuation in the fund is just $660 million. Its biggest constituents include Penn National Gaming, Sunrun, Deckers Outdoor and Caesars Entertainment — none of which are worth more than $14 billion.
These small-cap stocks were crushed during the height of the pandemic because unlike their larger peers, they have less margin for error. Their balance sheets tend to have less cash and more debt, so when business dries up during a recession, financial trouble follows.
At the end of October, a staggering 48% of the companies in the Russell 2000 were unprofitable, according to Schwab’s Sonders.
“There is a view that maybe that is the worst we’re going to get,” Sonders said, adding that the last time there was a peak in unprofitability, the index surged.
Small-cap stocks are also benefiting from the Federal Reserve’s extremely aggressive pandemic response. By cutting interest rates to zero and buying corporate debt, including junk bonds, the Fed successfully unlocked frozen credit markets last spring.
That’s huge for small-cap stocks because a large percentage of them are considered “zombie companies,” Sonders said, meaning they don’t earn enough money to even pay interest on debt.
So if credit markets froze again, perhaps due to the worsening pandemic and Washington’s failure to provide more stimulus, small-cap stocks could fall sharply.
Market bulls are clearly betting that won’t happen.