Everyone has that friend that you used to hang with regularly. Until, one day, plans don’t work out, and it starts an unintentional slow roll to seeing each other less and less. Everyone gets busy, and plans just stop working out until you both stop trying. It doesn’t mean you don’t care anymore. It just, well, lost momentum. 

That’s US Small Cap stocks these days too—losing momentum after a strong long-term run. US Small Caps, as measured by the Russell 2000 Index, have returned close to 8% per year for the last 20 years. However, more recently, they’ve stopped showing up for us, returning -3.4% per year for the last three years.   Why?

• Like most things in the market, it goes back to the 3 most important factors for any market: interest rates, earnings growth, and sentiment.

• Interest rates—and debt: All else equal, as rates rise, stock values tend to fall. And this can be especially true for stocks that have higher levels of debt because higher rates means their costs will likely rise. 

US Small Caps have 20-30% higher debt levels, on average, than US Large Caps.

In addition, the number of companies with negative operating income, as defined by earnings before interest and taxes, has been on the rise. This likely happened because of the long period of low rates, allowing negative gross earnings to be okay. In a higher rate environment, this becomes a risk to companies and investors—particularly if their liability costs rise as well.

• Earnings growth has been pretty negative quarter-over-quarter for the last 3 years, further supporting a drop in values:

  

• Given this, it doesn’t take much to have sentiment go negative. Particularly, when some of the largest sectors in the US Small Cap space are not what’s been most favored—meaning less in tech and more in economically sensitive sectors such as financials and industrials.

  

Interestingly, several of the tech names have increased in value and are expected to move up to the mid-cap indices, likely reducing the sector’s weight again.

So this begs the question, when could Small Caps be a place to invest again?

I think it could be soon-ish, within the next 6 months. What I would look for is clarity on the direction of interest rates, particularly rate cuts. Plus, because financials are such a high weighting in the index, confidence that some of the bank issues we’ve had are in the past. Even then, it’s important to understand the differences between companies behind the stocks. I often favor higher quality companies within Small Caps—with consistent earnings.

Just like when you see that friend again, you might look for a high quality way to get some momentum again.