Surging small cap stocks offer hope of U.S. growth rebound

NEW YORK (Reuters) – Big gains in small caps stocks are fueling hopes that a bounce in broader equity markets may stick, as investors ponder how quickly the U.S. economy can emerge from its coronavirus-fueled slowdown.

The small-cap Russell 2000 index rose 13.7{3c4481f38fc19dde56b7b1f4329b509c88239ba5565146922180ec5012de023f} in April, besting the benchmark S&P 500’s .SPX 12.7{3c4481f38fc19dde56b7b1f4329b509c88239ba5565146922180ec5012de023f} gain. Notably, the Russell’s rally accelerated at the end of the month, when it notched six straight days with gains of at least 1{3c4481f38fc19dde56b7b1f4329b509c88239ba5565146922180ec5012de023f}, its longest streak of such gains in two decades.

That outperformance is a good sign to some investors, who believe that domestically-focused small cap stocks tend to be more sensitive to economic fluctuations and are among the first areas of the market to reflect both downturns and rebounds. The index took an outsized hit as stocks tumbled earlier in the year amid concerns over how countrywide lockdowns would impact U.S. growth, with the Russell 2000 falling as much as 42{3c4481f38fc19dde56b7b1f4329b509c88239ba5565146922180ec5012de023f} from its highs, compared to a nearly 34{3c4481f38fc19dde56b7b1f4329b509c88239ba5565146922180ec5012de023f} drop for the S&P.

The spotlight on small caps comes as investors digest a bounce that has lifted the S&P 500 more than 28{3c4481f38fc19dde56b7b1f4329b509c88239ba5565146922180ec5012de023f} from its March lows, and U.S. states try to gradually reopen their economies without stoking a resurgence of coronavirus cases.

“People are believing that at some point in the third quarter we are going to get back to some semblance of what life was prior to all of this,” said Steve DeSanctis, equity strategist at Jefferies in New York.

Subsiding volatility is another positive sign for small caps, said Julian Emanuel, chief equity and derivative strategist at BTIG in New York. The spread between the Russell 2000 Volatility index .RVX and the S&P 500 Volatility index has narrowed after hitting a high in April, though it remains elevated in historical terms, he said.

Small cap stocks have tended to outperform their larger peers six to 12 months after volatility declines from extreme levels, Emanuel said.

(Graphic: Spread between Russell VIX and S&P 500 VIX IMAGE link: here)

Smaller stocks still have some headwinds to battle, as data is likely to remain dismal through the second quarter, potentially putting profits at risk for a number of companies. Wednesday’s release of the ADP National Employment Report, which showed private employers laid off a record 20.236 million workers in April, was a stark reminder of the road ahead.

Nearly one-third of companies in the Russell 2000 are unprofitable, and the number is likely to increase as they use cash to stay in business as the economy struggles to regain its footing, according to the Wells Fargo Investment Institute.

But even as growing optimism over the reopening of the economy has helped stocks surge, not all analysts are convinced the gains will keep coming.

“We have just gotten into the recession as well as the earnings contraction,” said Chris Haverland, global asset allocation strategist at Wells Fargo Investment Institute in Winston Salem, North Carolina. “The markets have gotten ahead of themselves given all the negative economic and earnings news that is going to be coming out in the next few months.”

The upcoming weeks could go a long way to determining whether small caps can extend their gains, as several states such as Georgia, Florida and California begin to reopen their economies. Signs that officials may need to reverse reopenings in the event of a virus resurgence would likely endanger the rally in small caps.

Nearly 135,000 Americans could die from COVID-19, the illness caused by the coronavirus, by early August, almost double prior projections, as social-distancing measures for curbing the pandemic are increasingly eased, such as those on restaurants and retail stores, health researchers said Monday.

“From our point of view, that sort of uncertainty is likely to put the brakes on this rally, at least in the near term,” said BTIG’s Emanuel.