Smaller stocks gain on bigger players as 2019 closes

Small and mid-cap stocks haven’t made quite as big gains this year as the larger indexes, but they could be poised for a breakout next year if the economy continues growing.

Small and midsize companies are typically more dependent on the domestic economy than larger companies. So, trading has been choppier for the smaller players in a year filled with trade tensions and economic angst. But worries about a potential recession have faded since midyear thanks to more positive reports on the economy and a supportive interest rate policy from the Federal Reserve.

Despite the volatility, both the Russell 2000 and S&P Mid Cap indexes have been close on the heels of larger counterparts like the S&P 500 throughout 2019, and could close more of that gap next year.

Investors have focused mainly on larger stocks, especially through futures, while small-cap stocks remain below their long-term average values and still have room to grow, according to Lori Calvasina, head of U.S. equity strategy at RBC Capital Markets, in a research report.

“We are now seeing evidence that a catch up trade in Small Cap may truly be underway and that it has room to run,” she said.

Still, investors need to see continued improvement in productivity, income and spending for a larger shift toward small cap stocks to take hold, Calvasina said.

One positive sign she points to is a steeper yield curve, or the difference between long-term and short-term Treasury yields. During the summer, long-term yields fell below short-term yields, a phenomenon that’s seen as a predictor of recessions. But as of Wednesday, the yield on the 10-year Treasury was 1.83% versus 1.63% for the 2-year Treasury.

Job growth has been a key support for the economy and the latest government data blew away forecasts. Consumer confidence remains high and consumer spending, which accounts for about 70% of the economy, is still going strong. Those solid measures have offset concerns about a shrinking manufacturing sector and slower growth from services, which make up the bulk of the U.S. economy.

Economic growth is still expected to slow in the coming year. A survey from the National Association for Business Economics shows that they expect economic growth to slow from 2.9% last year to 2.3% in 2019 and 1.8% in 2020.

Small caps are at their steepest discount to larger stocks since 2003 and could take off in 2020 if the economy continues growing, according to Jill Carey Hall, U.S. equity strategist at BofA Merrill Lynch Global Research. A resurgence from the manufacturing sector, for example, could reassure investors and give smaller stocks a lift.

Better forecasts from smaller companies also support a shift toward small cap stocks, she said. Utilities still remain the strongest sector for smaller stocks and provide a solid defensive hedge heading into 2020, she said.

More cyclical small-cap sectors, including technology and industrial stocks, would particularly benefit from improvements in the larger economic picture that could nudge investors toward riskier holdings.