The rise and fall of small-cap U.S. stocks was one of the most jarring market reversals this year. And 2019 is expected to only bring a modest recovery thanks to pressure from higher interest rates and concerns about peaking earnings growth.
Investing in smaller, domestically focused companies had been among most popular strategies in 2018, as tariff tensions and a fiscal stimulus boost made them into safe havens. But the so-called America First trade has completely unwound. The Russell 2000 Index has plunged 16 percent from an August record and is on track for the first annual decline since 2015.
Wall Street strategists are warning investors to brace for more turbulence. From the U.S.-China trade war to rising interest rates and cuts in profit estimates, there’s no shortage of headwinds for small firms, they say. Despite trading at the biggest discount to their large-cap counterparts in years, the risk-reward of small caps is unattractive at this late stage of the business cycle, Barclays analyst Venu Krishna cautioned in a note this week, forecasting the Russell 2000 to rise to 1,560 by the end of 2019, a 6.4 percent increase from current levels.
Jefferies is projecting the index to finish next year at 1,550, implying a 5.7 percent gain. Both estimates are below the gauge’s average 9.2 percent annual return over the past 10 years.
Flows into exchange-traded funds paint a more optimistic picture. Buyers continued to pile into ETFs tracking small-cap companies through the sector’s slide in September, allocating more than $25 billion for the year, topping the group’s 2017 flows.
For most of the year, domestic firms’ perceived insulation from global turmoil drove investor bullishness, so trade concerns have probably played a role in funds flows, according to Todd Rosenbluth, director of ETF research at CFRA Research.
Even riskier funds offering leveraged exposure to small caps have attracted a lot of interest, especially during October’s market volatility. The $809 million Direxion Daily Small Cap Bull 3X Shares fund, which gives investors three-times the daily performance of an index of small caps, took in more than $381 million in October, the most for any month going back to August 2011.
Direxion Investments managing director Sylvia Jablonski has seen quick and consistent inflows to funds that that have been falling the most, with investors betting on a near-term rebound.
Here’s what strategists are saying about the sector’s outlook:
Barclays, Deputy Head of U.S. Equity Research Venu Krishna