Small change: Smaller stocks are making a bigger noise

It’s just a small change so far, but smaller stocks may finally be wresting some of investors’ attention away from the huge companies that have so dominated the market for years.

Even before the coronavirus crisis sent markets spiraling, investors kept piling into bigger companies at the expense of smaller ones, particularly the tech giants that are reshaping economies and how we live our lives.

It made sense because these were companies that could take advantage of their global reach to drive strong growth in a plodding economy. And after the pandemic hit, they were still seen as safer bets than small-cap stocks, which are more likely to be money-losers and to have weaker financial cushions.

But in the last couple weeks, smaller companies like Winnebago, Big Lots and Supercuts-owner Regis have all shot higher more quickly than their bigger rivals. Of course, that’s after they plunged much more sharply in the sell-off that swamped markets earlier this year.

The recent performance has been strong enough to force Wall Street to start debating whether this could be the start of a longer-term trend. Smaller and bigger stocks have taken turns leading the market, typically waiting years before switching places. And investors have been waiting for more companies to join the giants in pushing the market higher, which is seen as a sign of a healthier market.

This most recent bounce for smaller stocks has come as investors swung from panic about the recession sweeping the global economy to optimism that growth could resume later this year as economies reopen. That could mean people RV-ing on a vacation instead of staying at a hotel, shopping for something other than toilet paper at Big Lots and going back to get haircuts at Regis’ stores, while still wearing masks.

As a group, the small stocks in the Russell 2000 leaped 27.4% after hitting a bottom on March 18, through Wednesday. That’s better than the 18.8% gain for the big stocks in the S&P 500 over the same span.

“While small caps lead the market lower, they also lead on the way coming out of the recession,” said Sandy Villere, portfolio manager at Villere & Co. Early last month, he and his team began looking at companies that could benefit as the economy picks up momentum, “things that got left for dead like smaller companies.”

Even after their recent gains, small stocks still look relatively cheap, according to Glenmede. “This portion of the market has been hit hard and probably stands the most to gain in the ensuing recovery,” strategists at Glenmede wrote in a recent report.

Going back to the end of World War II, small-cap stocks have done better than the rest of the market only when U.S. economic growth is above average, according to Jim Paulsen, chief investment strategist at Leuthold Group. Since 1948, small-cap stocks have beaten the rest of the market nearly two-thirds of the time and by 8.5% annually when the economy’s growth has been in the top quarter of its historical readings.

Of course, whether small-cap stocks have indeed turned a corner depends entirely on whether the U.S. economy is indeed about to turn higher, as markets are assuming. Some on Wall Street are still skeptical, given that the economy is likely in the midst of its worst quarterly performance since the Great Depression.

If the downturn lasts, smaller stocks will need to borrow to cover their shoftfalls, and lending markets may not be as kind to them as they are to bigger companies. Nearly a third of companies in the Russell 2000 are losing money, according to strategists at Wells Fargo Investment Institute. With smaller companies likely burning through cash to survive, the strategists recently downgraded their rating for small U.S. stocks from just “unfavorable” to “most unfavorable.”