A vicious six-month repricing has rattled investor nerves but has done little to make the US stock market cheap. An exception is small caps. And yet that’s the group that traders are bailing from the fastest as the threat of a recession looms.
The $49.3 billion iShares Russell 2000 ETF (ticker IWM), which tracks its namesake index of small-cap stocks, has lost over $4.3 billion year-to-date. This includes nine days of outflows in the last 10 sessions. Meanwhile, Charles Schwab’s $12.5 billion US Small-Cap ETF (SCHA) was drained of $309.9 million in Wednesday’s session, it’s largest one-day decrease since September 2021, according to data compiled by Bloomberg.
For bulls searching for signals that the worst is over, the exodus from smaller companies is ominous because the group is traditionally viewed as the most exposed to the domestic economy. The signal hits harder considering that among indexes kept by S&P, those firms trade as much as 25% cheaper than the rest of the market.
“Whenever there were headlines that a recovery was in play and all of a sudden all the case counts went down, the first stocks to rebound were the small caps,” Victoria Fernandez, chief market strategist at Crossmark Global Investments, said by phone. “I think you would see the reverse as people fear a recession.”
Smaller companies have been hit hard by this year’s selloff. The Russell 2000 Index has fallen as much as 32% from its recent high, compared with about 23% in the S&P 500 and 19% in the Dow Jones Industrial Average. Only the Nasdaq 100, whose valuation bloat has been widely chronicled, has suffered a comparable drop.
Even niche funds that have held up are losing money. The $110 million Invesco S&P SmallCap Energy ETF (PSCE) which has benefited from the run up of fuel costs that came as a result of Russia’s invasion of Ukraine, rose over 14% year-to-date. While it is one of a few positive small-cap funds in a sea of red, investors this year still yanked $11.4 million from the fund.
“You watch small-cap flows to see how people are betting on a recession, and I would naturally assume small caps to be hurt the worst if people thought there was going to be one,” said Eric Balchunas, an ETF analyst for Bloomberg Intelligence.
But there’s a glimmer of hope for those brave enough to ride out the bear-market volatility. The Russell 2000 tends to hit a bottom before a recession is over, according to BI analyst Michael Casper. This means that if a recession is currently underway, the bottoming process may have already begun. The Russell 2000 also tends to outperform the S&P 500 after it hits a trough during a bear market, he said.
“It does take some time to recover those prior highs, but usually as sentiment recovers, small caps are the first things to bounce back,” Casper says.
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