U.S. Small Caps Flex Muscle In The October Relief Rally

By Mark Barnes, PhD, and Christine Haggerty, Global Investment Research

After leading the global equity selloff earlier this year, US small caps have begun showing signs of life since summer, riding the periodic bursts of optimism about the outlook for inflation and hopes for some let-up in future Fed rate hikes. Albeit brief, these glimmers of small-cap vigor suggest how the tides of investor favor might flow once the pivot does come and/or risk appetite improves more resolutely.

As shown below, the Russell 2000 took a bigger beating than the Russell 1000 and broad markets elsewhere in the brutal first-half meltdown. But as sentiment and equity markets have revived more broadly, the US small-cap index’s fortunes have taken a turn for the better. Buoyed by a 10.4% jump in July, the Russell 2000 sustained smaller losses than both the Russell 1000 and the FTSE All-World ex USA in Q3. It also strongly outpaced both indexes in the global equity rally in October.

Though the broader US stock market still ranked among the worst performers globally for the year to date ending October 31, the Russell 2000 has fared modestly better than its large-cap counterpart.

FTSE Russell equity returns (TR, LC %)

US small caps ride rotation into cyclical stocks in October

The US stock rally in October was dominated by a strong broad-based rebound in cyclical stocks, many of which had been the hardest hit in this year’s broad market downturn. All 11 industries in the US posted positive absolute returns for the month. Topping the list was energy, which extended its yearlong winning streak with a 23.7% gain, followed by industrials (up 13.0%), financials (up 11.9%), telecom (up 11.1%) and basic materials (up 9.6%). The biggest laggards were consumer discretionary and technology, which posted respective increases of 2.5% and 4.2%.

The Russell 2000 had a clear advantage over the large-cap index in this cyclical rotation. As illustrated below, the small-cap index has a much larger exposure to outperforming energy, industrials, financials, and basic materials stocks than the Russell 1000 (with an overweight of 13 percentage points) and far less so to underperforming growth stocks.

Industry weights (%) – as of October 31, 2022

Broken down by industry-weighted contributions to returns, small-caps outstripped their large-cap peers in eight of 11 industries, led by consumer discretionary, financials, industrials, and real estate.

Industry-weighted contributions to returns (%) – One month ended October 31, 2022

The chart below illustrates how the small-cap index’s greater tilt to cyclical outperformers played out across sectors last month. Though cyclically sensitive sectors within the energy, financials, industrials, and consumer discretionary were among the top 10 contributors for both Russell indexes, oil & gas, banks, REITs, travel & leisure and industrial support services were far more additive to small-cap returns than their large-cap peers.

Top 10 sector-weight contributions to returns (TR %) – one month ended October 31, 2022

Poised for a sustained comeback?

As our colleague, Catherine Yoshimoto wrote in a recent blog post, after a long stretch of playing second fiddle to large-cap stocks, the case for a more durable revival in US small-cap leadership has grown more compelling. As she points out, smaller US stocks are trading among the lowest valuation multiples relative to US large caps over the past decade, despite significantly stronger consensus earnings growth forecasts. Smaller companies also typically derive a bigger share of their revenues from domestic sources, so their stocks should be less vulnerable to the pressures facing their more multinational peers from the recent surge in the US dollar and gloomier overseas business outlook.

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