(Bloomberg) -- Count small-cap stocks among the casualties of the quickly unraveling reflation trade.
The Russell 2000 Index fell more than 1% on Tuesday as the fastest inflation since 2008 fueled concern over pricing pressures and the growth potential of smaller U.S. companies. The retreat contrasts with a gain in the Nasdaq 100, where technology megacaps are increasingly favored for their strong earnings potential.
Poised to trail the Nasdaq 100 for a second month in a row, the Russell 2000 has now wiped out its year-to-date outperformance, which at one point reached 19 percentage points against the tech-heavy gauge. At the same time, short sellers are circling back. Bearish wagers against the iShares Russell 2000 ETF (ticker IWM) are now at the highest level since October, according to data compiled by IHS Markit.
“This is a big reversal, but part of a regime change,” said Mike Bailey, director of research at FBB Capital Partners. “Investors got comfortable with a narrative that small-caps and cyclicals would ride into the sunset this year in a grand recovery trade. But that story faded when interest rates collapsed and tech earnings grew white hot.”
To some, it’s a part of a marketwide unwinding of the cyclical trade that got a big boost after November’s rollout of Covid-19 vaccines. Back then, the Russell 2000 beat the Nasdaq 100 six months in a row, with gains running six times as large.
Now, the delta variant of the coronavirus is quickly spreading. And the pickup in inflation is stoking concerns that small companies won’t be able to pass rising costs on to customers while the Federal Reserve may be forced to raise interest rates sooner than expected.
“There’s been a reversal where growth has outperformed again and part of that is because it looks like future growth will not be as great, and so the cyclical play seems to be playing out a bit,” said Stephen Dover (NYSE:DOV), chief market strategist and head of Franklin Templeton Investment Institute. “Technology companies tend to have more pricing power than the cyclical companies at this point and are likely to have more pricing power in the future.”
Small-caps are left behind in an advance that has continued to push other major indexes like the Nasdaq 100 and the S&P 500 to new highs. The Russell 2000 last scored an all-time high in March and has yet to break out.
The lagging returns have led to a discount to large-caps. Based on its price to forward-earnings ratio, the Russell 2000 traded at a multiple that’s 0.82 times the Russell 1000’s, data compiled by Bank of America Corp (NYSE:BAC). show. Historically, small-caps tended to fetch a 3% premium.
Despite attractive valuations, bears are doubling down on bets against small-caps. After falling to a two-year low of roughly 4% in March, short interest on the iShares ETF tracking the Russell 2000 has risen to 11% of its outstanding shares, according to IHS Markit’s data.
Even so, Jeff Schulze, a strategist at ClearBridge Investments, isn’t ready to give up on small-caps just yet. He sees economic activity remaining elevated in the second half of this year amid excess savings and a potential spike in business spending.
“All of this creates a situation where you have strong economic activity and you have very robust earnings growth, which tends to favor value and small cap,” Schulze said. “As you see 10-year Treasuries bottom here and start to move higher; I think that’s going to be the catalyst for small-cap outperformance once again.”
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