Morgan Stanley
  • Thoughts on the Market Podcast
  • Mar 15, 2021

A Tougher Road Ahead for Small Caps?

With Mike Wilson
U.S. Equities Research for Investors


Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief, U.S. Equity Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, March 15th, at 11:30 a.m. in New York. So let's get after it.

Long term interest rates have finally started to catch up to what other asset markets have been telling us for months: that the recession is behind us and the economy is likely to be booming later this year. The rise in rates has had a negative effect on equity valuations, especially the most expensive stocks that benefited during the pandemic. As a result, cyclicals and small caps, two areas we favored, have outperformed as growth stocks have lagged. Year to date, the value indices have outperformed growth by about 10%, and the small cap Russell 2000 is up 19%. Meanwhile, the Nasdaq 100 is flat.

From our perspective, the equity market is doing exactly what it should be at this stage of the recovery. The recent non-linear move in long-term interest rates means equity investors can no longer ignore this risk. The rates market is mispriced, and now that the seal has been broken, there's a good chance equity markets start to price in the next 50bps move, even if it's months away. What this really means is that equity valuations are likely to fall this year - a key part of our call for 2021.

That view is informed by our cycle analysis, something core to our overall investment strategy process. Many of our best out of consensus calls in the past have been based on this cycle analysis. Falling equity valuations is what always happens at this stage of the recovery, and we see little reason to think it will be different this time. Having said that, the recent fiscal stimulus may provide one last final push higher as this money leaks into the market. We would use that strength to reduce positions in the more expensive parts of the market.

When we upgraded small caps last April, our thesis was that we would experience a V-shape recovery in the economy, and the government subsidy of the unemployment cycle would accrue to the bottom line of corporations, especially small caps. Valuations would expand in anticipation of this recovery and small caps would outperform. Since then, the Russell 2000 has outperformed the S&P 500 and Nasdaq 100 by 50% and 40%, respectively. Half of this is due to the better earnings revisions as operating leverage has accrued to smaller cap companies at a faster rate, while the other half is due to greater valuation expansion.

Now we think that period of extraordinary outperformance and earnings revisions and valuation expansion may be coming to an end. Therefore, we're downgrading small caps today. As the economy reopens, we think there's a growing risk of margin disappointment as we discover it's a lot harder to turn the economy on than it is to turn it off. Much of this risk will be industry and company specific. And we are starting to hear concerns about labor availability and supply chain shortages. Specifically, purchasing manager surveys are indicating a spike in costs. Just as small cap companies accrued a disproportionate share of the positive operating leverage dynamics, they are likely to feel the brunt of the cost pressures we think could materialize during the reopening phase. Much like at the end of the last cycle, smaller cap companies could prove to have less ability to manage cost surprises.

On valuation, the Russell 2000 is now trading at 34x forward earnings - a 50% premium to the S&P 500. This doesn't mean smaller cap company stocks can't work; however, the risk reward at this point is no longer favorable. Looking forward, we expect 2021 to be a year of stock picking, with winners and losers as the economy reopens. This is very different than last year when basically everyone was a winner, as the market anticipated things getting better. In that regard, it's often better to travel, than arrive, as an investor.

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After almost a year of extraordinary outperformance, could small caps see more difficulties ahead as re-opening dynamics up the risk of cost pressures?

Each week, Mike Wilson offers his perspective on the forces shaping the markets and how to separate the signal from the noise. Listen to his most recent episode and check out those of his colleagues from across Morgan Stanley Research.

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