A smoother road ahead for small caps?

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February 12, 2021

Last year was painful, but we think this year will be different. The market is reflecting the expectation of a swift recovery and additional stimulus has lifted investor spirits. In the wake of vaccine distribution, out-of-favor sectors are likely to come back and small businesses should have a smoother road ahead, according to Alicia Levine, chief strategist at BNY Mellon Investment Management.

We believe the rotation from growth to cyclical stocks has already begun. Sectors considered too risky in the aftermath of the pandemic—like financials, industrials, energy and materials—have started to come back, as high growth sectors have slightly receded (Figure 1). But opportunity is not solely found in industries already showing signs of recovery; it’s also where the return potential has not yet been fully realized: at the epicenter of the crisis.

“What really hasn’t worked are travel and leisure, in-person gaming and other high-touch areas that were at the epicenter of the Covid-19 recession,” Levine says. “If you look at where Americans are spending money, they’re spending it on things. But services likely won’t be coming back until the population is vaccinated.”

Chart is for illustrative purposes only, and is not a reliable indicator of current or future performance.

Past Performance is no guarantee of future results

Although hotels, airlines and other service industries may not see a full recovery until the lion’s share of the population is vaccinated, the epicenter may currently be ripe for value opportunities, Levine says. Herd immunity is expected to manifest later this year and a new US political landscape could mean larger fiscal stimulus on the horizon. Together, these two factors may allow service industries to undergo a resurgence sooner rather than later.

“I think it’s a great place to find value and it’s still cheap enough that there is opportunity to catch the recovery on the upswing” Levine says. “Every day that there are doubts surrounding vaccination, is a day for this opportunity. There’s going to be a push and pull, but ultimately, the demand for services will likely not be going away.”

Big money for small businesses

Fiscal packages have been a lifeline for small businesses throughout the pandemic. In December, Congress passed a US$892 stimulus package, which renewed a small business lending program by US$284 billion.1 The package also included US$600 checks per person for millions of Americans and unemployment benefits of up to US$300 per week for 11 weeks through March.2 Already $130B has been distributed from the December stimulus to qualifying individuals in the first 12 days of the year. Additionally, Democrats took control of the Senate at the start of the year, which paved the way for even more stimulus. Shortly after, President Joe Biden unveiled plans for a US$1.9 trillion coronavirus aid package, including additional direct payments of US$1,400 to most Americans and an increase in the federal weekly unemployment benefit to US$400.3

A fiscal package of this calibre will likely lead to increased consumer spending, which bodes well for small and mid-cap earnings as money is recycled back into the economy, Levine says. In fact, as the return to normal becomes a near-term prospect, the market has begun to reflect optimism for the future of small businesses. Last November, the Russell 2000 rose 18.3%, and in December, over 8%.4

“The Russell 2000 has the highest percentage of companies without profits, where nearly one-third of its constituents have no earnings, so why buy them?” Levine says. “Because that’s where we think there will likely be the most juice in the recovery. Large companies were winners during Covid lockdowns, but smaller companies are the ones that will grow faster in the recovery.”

Just like cyclicals, their performance is tied to the economic recovery. As tailwinds begin to form, history may play out yet again as small caps follow their historic post-recession path (Figure 2).

Chart is for illustrative purposes only, and is not a reliable indicator of current or future performance.

Past performance is no guarantee of future results.

“While past performance is no guarantee of future results, following recessions, small and mid-cap stocks tend to lead the recovery for several years because they’re the highest beta and they have the greatest rate of change,” Levine says.

If small caps and cyclicals are poised to lead the recovery, it should come as no surprise that Levine is bullish on regional banks. This is because they should be able to boost dividends as the economy grows stronger, according to Levine. Secondly, after the global financial crisis of 2008-09, banks came under increased regulation, which led to more stringent lending measures and requirements for better capitalization. This may have helped to insulate them from a worse outcome in the Covid-19 recession.5

“The financial sector was heavily regulated after the Great Recession. And this time around, financials were not the cause,” Levine says. “We think they are well capitalized for the bad economy. And in many ways, their balance sheets may be very strong so they have capital they can return,” she concludes.

1 Reuters: After months of inaction, U.S. Congress approves $892 billion COVID-19 relief package. December 21, 2020.

2 Washington Post: Senate majority leader announces approximately $900 billion deal on emergency relief package. December 20, 2020.

3 CNBC: Biden’s $1.9 trillion Covid relief plan calls for stimulus checks, unemployment support and more. January 14, 2021.

4 Investor’s Business Daily: Stock Market Forecast for 2021 could be bumpier than you think. December 31, 2020.

5 The Economist: How resilient are the banks? July 2, 2020.



S&P 500 Index: The Standard & Poor's 500 (S&P 500) Composite Stock Price Index is a widely accepted, unmanaged index of U.S. stock market performance.

Russell 2000 Index: The Russell 2000 Index is an unmanaged index of small-cap stock market performance and is composed of the 2,000 smallest companies in the Russell 3000 Index. The Russell 3000 Index is composed of the 3000 largest U.S. companies based on total market capitalization.

Beta: Beta is a measure of the volatility or systematic risk of a security or portfolio compared to the market as a whole. A beta greater (lower) than 1.00 indicates that the fund is more (less) sensitive to that market's movements.

Figure 1 – S&P 500 Sector definitions:

Consumer Discretionary: Discretionary consumer products are luxury items or services that are not necessary for survival. The demand for these items depends on economic conditions and the wealth of individuals. Products include cars, jewelry, sporting goods, and electronic devices. Luxury experiences include trips, stays at hotels, or dining in a posh restaurant.

Communication Services: The communication services sector consists of companies that keep people connected. This includes internet providers and phone plan providers. The sector includes media, entertainment, and interactive media & services companies.

Consumer Staples: Consumer staples companies provide all the necessities of life. This includes food and beverage companies, household product providers, and personal product providers. Consumer staple companies are well and their products are regularly seen in stores.

Energy: The energy sector consists of all companies that play a part in the oil, gas, and consumable fuels business. This includes companies that find, drill, and extract the commodity. It also includes the companies that refine the material and companies that provide or manufacturer the equipment used in the refinement process. Companies such as Exxon Mobil and Chevron extract and refine gas, while companies like Kinder Morgan transport fuel to gas stations.

Financials: The financial sector includes all companies involved in finance, investing, and the movement or storage of money. It includes banks, credit card issuers, credit unions, insurance companies, and mortgage real estate investment trusts (REITs). Companies within this sector are usually relatively stable, as many are mature, well-established firms.

Healthcare: Health care consists of medical supply companies, pharmaceutical companies, and scientific-based operations or services that aim to improve the human body or mind.

Information Technology: The information technology – IT – sector consists of companies that develop or distribute technological items or services and includes internet companies. Technology products include computers, microprocessors, and operating systems.

Industrials: Industrials include a wide range of companies, from airlines and railroad companies to military weapons manufacturers. Since the range of companies is so large, the sector has 14 different industries. Two of the largest industries are Aerospace & Defense and Construction & Engineering.

Materials: Companies within the materials sector provide the raw material needed for other sectors to function. This includes the mining companies that provide gold, zinc, and copper, and forestry companies that provide wood. Companies that are not typically associated with materials but are in the sector include container and packaging companies.

Utilities: Utility companies provide or generate electricity, water, and gas to buildings and households. Many utility companies are developing more renewable energy sources.

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