Wall Street week ahead: small-cap shares poised to benefit from shift to value

Beleaguered shares of small US companies are set for a bump in performance as value stocks have risen, market analysts say, but small caps could quickly fade again with an economic setback.

The small-cap Russell 2000 index has lagged the benchmark S&P 500 for much of 2019 and has yet to escape the bear market it confirmed last December.

Still, so far this quarter, the Russell 2000 has risen 4.6%, edging out the 3.6% rise in the S&P 500. The Russell's outperformance is in tandem with the S&P 500 Value index, whose 5.2% quarter-to-date climb has outpaced the S&P 500 Growth index's 2.3% advance over the same period.

Improving economic sentiment has prompted some investors to take a second look at undeperformers among both value stocks and small-cap shares. Value shares tend to be concentrated in economically sensitive sectors such as financials and energy. Shares of small-cap companies, which tend to be more domestically focused than their large-cap counterparts, often track investors' outlook on the US economy.

Reflecting growing economic optimism, the benchmark 10-year Treasury yield has moved well off its early September lows, and the yield curve between 3-month bills and 10-year notes has steepened. As a result, some investors believe US small-cap stocks are set to rally.

The performance of financial shares, in particular, has improved as yields have risen, which could help boost small-cap shares. Financials make up 20% of the Russell 2000, as compared to 13% of the S&P 500.

"Higher rates tell us that you've got a stronger economy," said Gary Bradshaw, senior vice president and portfolio manager at Hodges Capital Management in Dallas. "Small caps, which have lagged the large caps, can certainly catch up (given) this rotation into value."

In recent months, Bradshaw said, Hodges has added positions in small-cap value companies such as oil and natural gas companies Matador Resources Co and Parsley Energy Inc as well as Brinker International Inc, which owns Chili's restaurants.

Though some market analysts are skeptical that large-cap value shares will sustain their market leadership, the improving earnings backdrop for small-cap companies could nonetheless boost their shares.

Earlier this year, the earnings growth rate for small-cap companies lagged that of large-cap companies, in an aberration from usual patterns, said Lori Calvasina, head of US equity strategy at RBC Capital Markets in New York. But since then, small-cap earnings growth has recovered.

"People like small caps because they offer superior earnings growth longer-term," she said. "You couldn't really say that based on these stats at the beginning of the year, but now we look at these stats and the normal relationship is returning."

Still, the outlook for small-cap shares is highly dependent on US economic data, which suggest a slowdown. The Institute of Supply Management's widely followed manufacturing index, for instance, has indicated a contraction in US factory activity for three straight months. A US-China trade agreement would help bolster economic indicators in the manufacturing and industrial sectors, but it remains tentative.

Data on October US industrial production and retail sales, along with the National Federation of Independent Business's monthly small business survey, are scheduled for release next week.

"If we don't get a deal on trade, if we get more indications that the US economy is weaker, small caps are going to get crushed," said Steven DeSanctis, equity strategist at Jefferies in New York. "But I see (economic) growth holding up."