This Trend In Small-Cap Stocks Has Negative Short And Long-Term Implications

Small Companies Play An Important Role In The Economy And Markets.

The trend since 2007 of capital outflows from US small-cap funds has worrying short- and long-term implications.

Of more immediate concern is the divergence of fund flows and the Russell 2000 small-cap index. Since 2007 periods of significant capital outflows from small-cap funds have either preceded or coincided with sharp declines in the Russell 2000 and broad market indices. We are currently experiencing the greatest divergence between capital flows and the Russell 2000 since 2007, which does not bode well for the near-term prospects for stock markets.

The bull market of the past decade, without investor enthusiasm for small-cap stocks, is a testament to the narrow leadership of equity markets, which rested with the FAANG stocks, Microsoft, and a relatively small number of other issues. A market that is dependent on a relatively small number of large-cap stocks is inherently vulnerable to above-average volatility, in that a change of trend by just a handful of these shares would have a significant impact on markets. Indeed, almost 23% of the S$P 500 is comprised of just 5 stocks, which suggests the current era of muted market volatility will give way to substantial volatility when these shares eventually experience a correction/bear market.

The lack of investor interest in small caps also has economic consequences, as it raises the cost of capital for smaller companies by constraining share valuation. A higher cost of capital can limit growth, which in turn can reduce the creation of new jobs. Smaller companies have typically produced the bulk of new jobs in the economy.

Small-cap stocks, because of the higher growth prospects, have historically been a favoured sector during bull markets, particularly by retail investors. That this is not currently the case is but another anomaly in these unprecedented times.

A return to a more positive view by investors for small-cap stocks will likely require of broadening of market leadership, which would entail a stumble by current market leaders that would produce a good deal of market volatility.

This scenario is in keeping with our expectation that the 2020s will be a volatility and challenging decade for investors that will present both great risks and opportunities.

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Jonathan Baird CFA