Bets on Biden-Led Stimulus Fuel Outperformance by Small Stocks

10/29/2020 | 04:45am

By Amrith Ramkumar

Small stocks are outpacing larger companies by the greatest amount in years so far this month, underscoring investors' bets on Democrats gaining control in Washington and ramping up spending to support the economy.

Despite this week's slide, fueled by rising coronavirus cases around the world, the Russell 2000 of small-cap companies is still up 2.4% in October. That compares with a 2.7% drop for the S&P 500 and would be the largest such outperformance for any month since November 2016, the month President Trump was elected, according to Dow Jones Market Data. The Russell is outpacing the Dow Jones Industrial Average by 6.9 percentage points, which would be the largest monthly gap in more than a decade.

In the past week, the Russell is down 3.8%, compared with a 4.8% drop for the S&P 500 and a 6% fall for the Dow. The Russell has led even though smaller companies would be hard-hit by any new lockdown measures in the U.S. Earnings at these companies tend to rise and fall with the performance of the economy, but investors are anticipating that a victory by Democratic presidential nominee Joe Biden will lead to larger spending programs on everything from infrastructure to renewable-energy projects.

Similar wagers were made four years ago after Mr. Trump's surprising victory, when investors bet that spending on infrastructure programs and deregulation would support small-caps. Many of those wagers unwound after a large infrastructure bill never materialized, and small companies continued lagging behind their larger peers as they have for much of the past decade. Since the 2016 election, the S&P has risen 53%, while the Russell is up 29%.

But nearly four years later, investors are favoring small stocks again. Many investors are hopeful that greater fiscal spending can offset corporate-tax increases or greater regulation that many investors expect in a "blue wave" scenario that sees Democrats win the White House and control in the Senate.

"There is this notion that the fiscal stimulus will overwhelm any tax implications that a blue wave might bring," said Dan Cole, co-manager of the Columbia Small Cap Growth Fund. He has been increasing holdings of businesses like Planet Fitness Inc. and tax-software company Avalara Inc., recently.

The Russell 2000 is narrowing some of its longstanding gap with the S&P, which has been lifted lately by large technology companies like Apple Inc. and Microsoft Corp. With a market value around $2 trillion, Apple is roughly as large as the entire Russell 2000 by itself.

The Russell's recent outperformance comes with some investors wagering that more government spending will lift so-called cyclical companies, whose fortunes are tied to the economic outlook. Those include smaller companies, banks, manufacturers and commodity producers that tend to perform well as the economy exits a recession. In another sign investors are positioning for more stimulus, longer-term Treasury yields have risen lately, a development that signals traders are positioning for stronger growth and inflation. Bond yields climb as prices fall.

Some of the gains also mimic investors' recent bets on larger companies that help with remote work and learning or leisure while stuck at home. Smaller companies lifting the Russell with gains of at least 30% this month include home-goods retailer Bed Bath & Beyond Inc., home-fitness firm Nautilus Inc., action-camera maker GoPro Inc. and organization-products seller the Container Store Group Inc.

Still, concerns about rising coronavirus cases and the prospect of fresh lockdown measures could pose a new threat to the outperformance in small-caps. Because small-caps' profits would be hit harder by any new restrictions, many analysts say further stimulus measures will be needed to support the group until a coronavirus vaccine is distributed.

"The economy doesn't have to get back to normal. We just have to have visibility into it and confidence that it's coming," said Jeff Buchbinder, equity strategist at LPL Financial. LPL recently boosted its view on small-caps to in line with its market benchmark from a negative stance.

Recent negotiations between Democrats in the House of Representatives and the White House over a second round of coronavirus stimulus have stalled, amplifying questions about whether the two sides will reach a deal after the election but before the next administration begins.

If a deal is reached, some investors think smaller companies are well positioned to climb further. The Russell 2000 last hit a record in August 2018 and has trailed major indexes for years, giving it room to rise in the months ahead, some analysts said. The Dow industrials hit their last record in February, while the more technology-laden S&P 500 and Nasdaq Composite reached new highs in early September.

Still, some traders caution that the economic recovery is already slowing down, a trend that could prompt investors to once again favor larger companies more directly tied to technology and remote working.

Some market watchers are also nervous about the role of increased speculation by individual investors using apps like Robinhood in driving the rally. Trading activity in companies with share prices below $5 has risen recently, and some investors have even been buying shares of companies on the verge of bankruptcy.

Rental-car company Hertz Global Holdings Inc. has been one of the Russell 2000's top performers this month on a percentage basis, with its shares rising 62% to $1.80 after it lined up $1.65 billion in financing to carry itself through bankruptcy.

"Because small-caps are a riskier asset class, it is a good proxy for investors' risk appetite," said Angelo Kourkafas, investment strategist at Edward Jones. "You can definitely connect the two." The firm is recommending investors generally trim positions in areas that have outperformed lately like large technology stocks and bolster holdings in areas lagging behind like small-caps.

Write to Amrith Ramkumar at amrith.ramkumar@wsj.com

(END) Dow Jones Newswires

10-29-20 0544ET

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