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Small Caps May Have Challenging Period Ahead: BofA

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Bloomberg Aug 8, 2024 11:59 · 18.5k Views

Jill Carey Hall, BofA Securities US equity strategist, says there may be a challenging period ahead for the Russell 2000 but she sees pockets of opportunity in small-cap stocks in the near term on "Bloomberg The Close."

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  • 00:00 Small caps are really showing that they can kind of punch the weight with the large cap names that's faded over the last few days.
  • 00:05 Does that continue?
  • 00:08 Well, thanks for having me.
  • 00:09 I think from from here, what's going to matter is earning.
  • 00:11 So our view has been that, you know, one of the the necessary conditions for the the Russell 2000 rally was that we could see more confidence in inflation slowing and more confidence that the Fed will be able to cut rates.
  • 00:23 That happened a few weeks ago and then was a big driver of the rally.
  • 00:26 But I think now the, the other thing we're looking for is
  • 00:30 confidence that fundamentals for small caps can improve.
  • 00:33 And, and I think a lot of investors are looking at the earnings story because
  • 00:36 back at the start of the year,
  • 00:39 analysts were were expecting that by this earnings season, small cap profits would have recovered, would have been very positive, would have been outpacing large cap profits.
  • 00:47 And that hasn't happened.
  • 00:48 The numbers have just continued to be cut.
  • 00:51 And this earnings season, it's it's been relatively weak for small caps so far.
  • 00:54 We still have a lot more reporting to go, but we're seeing, you know much fewer beats, much weaker guidance than in large caps.
  • 01:00 And when we looked at corporate sentiment on earnings calls, we're seeing so far this record negative spread between the small cap and large cap corporate sentiment.
  • 01:09 So
  • 01:10 I think until we can see
  • 01:12 the fundamental trends turn around the the small cap rally is likely to
  • 01:15 you know, we we to pause from here.
  • 01:17 But but if we can see the the fundamental shift that gives us confidence in that very back end loaded earnings recovery, then the the rally could pick up again.
  • 01:25 It'll be interesting to see if that happens.
  • 01:26 I mean, we're already worked our way to about half the Russell 2000 in terms of earnings reports here.
  • 01:30 So we'll see if that other half
  • 01:32 actually shows something different.
  • 01:34 I am curious about the correlations to the macro economy to the economic conditions that is there was a lot of talk here
  • 01:40 about that.
  • 01:41 If you do think we're in a recession or at least headed towards
  • 01:44 a slumping economy of some degree or another, that small caps have a higher correlation than some of those large cap names, are you finding that holding?
  • 01:52 Yeah.
  • 01:52 I mean, I think, you know, we've, we've looked at the the correlations of small caps to, to macro data and to various indicators.
  • 01:59 The the ISM manufacturing indicator is still one of the most correlated indicators with
  • 02:04 not only corporate profits overall, but with small versus large cap relative performance.
  • 02:08 So we've obviously seen
  • 02:09 several weak, weak months in the the ISM,
  • 02:13 you know, macro data.
  • 02:14 We do continue to expect a soft landing in the US, but
  • 02:17 you know, typically these
  • 02:19 when we look at different macroeconomic regimes, we've we've been in a recovery regime since earlier this year.
  • 02:25 Last year we had some weakness, we had an earnings recession in the US
  • 02:30 Small caps typically do well coming out of that and when profits recover.
  • 02:34 But, but now obviously we're, we're watching a lot of the macro data and if it were to start to weaken further than, you know, in those macro downturns, that's typically a period where you want to own quality
  • 02:43 and, and larger caps,
  • 02:45 right?
  • 02:45 So Jill, if we sort of get through this soft patch,
  • 02:49 do we revert back to the rotation
  • 02:51 trade that we were all talking about like what 10 days ago in terms of cell tech by small caps?
  • 02:58 I think broadly, you know, we, we have expected a rotation in the market, you know, particularly within the S&P 500 out of the the MAG 7 and into the other 493.
  • 03:07 And that's where you are seeing those earnings trends start to shift.
  • 03:11 You've seen more sustainable evidence of that within large caps that the earnings for the other 493 are picking up versus slowing for the MAG 7, which are also investing heavily in, in CapEx.
  • 03:21 And, and so the, that, that story is there for small caps as well, but it's just taking longer to play out and we're not seeing as much evidence of it.
  • 03:28 So, you know, I think if, if we do see soft landing, no recession and if the the small cap earnings data can improve, then then that rotation may likely continue, especially if we're in an environment of, of Fed cuts given all of the refinancing risk for the Russell.
  • 03:43 So near term, you know, bottom line, we we still think there's opportunity within pockets of small caps, particularly those that are higher quality have been able to beat and raise, see upward estimate revisions.
  • 03:54 But for the Russell 2000, overall, we think it may be a challenging period.
  • 03:57 Volatility also typically picks up in this.
  • 04:00 Especially in election years.
  • 04:01 So owning quality and sticking with large caps for the near term
  • 04:05 may be more prudent.
  • 04:07 Yeah, so I'm going to say so I'm looking at the VIX at the 26th,
  • 04:10 far cry from 60, but also far
  • 04:12 cry from 12:00.
  • 04:13 If we're in a more consistent higher volatility
  • 04:16 regime.
  • 04:17 That's US tech large cap, Yeah,
  • 04:20 large cap over small and and really quality.
  • 04:23 I mean, when we look at what's been consistent when volatility picks up, just
  • 04:27 stocks that have stable rather than volatile earnings have been a very consistent outperformer in those environments where the VIX picks up.
  • 04:36 You know, I think for for large caps, we've been more cautious on, on tech relative to some of the other sectors.
  • 04:42 You know, mag mag 7 stocks have been relatively more expensive and, and over owned by fund managers versus some of the other cyclical areas.
  • 04:50 I think we even if we're in a slowing macro environment, we still expect a CapEx cycle in the US, We have a lot of aging and crumbling infrastructure.
  • 04:58 We have reshoring.
  • 04:59 So even though.
  • 05:00 Is something that's usually cyclical, there may be more of a case for a Capec cycle this time around.
  • 05:05 So,
  • 05:05 you know, I, we still think the rotation is likely, but but near term if, if there are concerns around the slowdown, we think sticking with, with high quality stocks that makes sense.