2023-11-06 17:58:51 ET
Summary
- The small cap ETF has rebounded from key lows due to dovish Fed comments and weak jobs data.
- Small caps may be reversing their underperformance compared to large caps as their valuation discount exceeds previous extremes.
- There are risks to earnings from high real yields and slowing economic growth, but IJR should outperform cash and the broader market.
The iShares Core S&P Small-Cap ETF ( IJR ) has bounced strongly off of key lows, supported by the fall in real yields driven by last week's dovish Fed comments and weak jobs data. I noted in a previous article in September that strong historical fundamental growth and cheap valuations make the IJR a good long-term buy, and the weakness since then and subsequent recovery have strengthened both the valuation and technical case.
Small caps' long period of underperformance versus large caps may be reversing as their valuation discount to large caps exceeds the 1999 extremes, which gave way to a decade of outperformance. Even after last week's strong rally, the S&P600 Small Cap index still trades at valuation levels on a par with the major lows seen in 2020 and 2009. High real interest rates act as a high hurdle rate for required returns, and pose a threat to buyback growth, as the IJR yields just 1.6%. However, outperformance versus cash, and particularly against large cap stocks still seems likely.
The IJR ETF
The IJR tracks a market-cap-weighted index of primarily small-cap US stocks. The S&P Committee selects 600 stocks representing about 3% of the publicly available market. The ETF has a significantly lower exposure to technology stocks and higher exposure to financial stocks when compared with large cap stock indices, and with mega cap tech stocks outperforming, the IJR has lost 18% versus the SPX since March. The IJR has continued to outperform the iShares Russell 2000 ETF ( IWM ), however, as has been the long-term trend due in large part to its far stricter criteria regarding the profitability of firms included in the index. The IJR also has a lower expense ratio of 0.06% versus the IWM's 0.19%.
The rally from the October lows is significant technically as they mark a hold of the September 2020 lows and the 2020 highs. While I generally do not put a great deal of weight on trends, the channel in the IJR in place over the past 18 months is well established and suggests a rise back up to resistance around $104.
Fundamentally, small cap stocks are well placed to benefit from a continued decline in real bond yields as they are generally more heavily indebted than large cap stocks. Equity investors had feared that continued increases in real rates would undermine small cap earnings, but last week's yield plunge has calmed those fears.
Valuations Consistent With 14% Annual Returns For A Decade
The S&P600 Small Cap index trades at a PE ratio of just 15x, which is below the level seen at the 2020 Covid crash lows, and just above the 2009 financial crisis lows. Even if we strip out the impact of rising profit margins, which should be expected to mean revert lower over the coming years, the cyclically adjusted PE ratio is still lower than at any point over the past 30 years outside of these two major lows.
Current valuations are consistent with annual 10-year total returns on the S&P600 Small Cap index of almost 14%. This reflects the extent of the market's current undervaluation and the historical growth rate of fundamentals, which has averaged almost 10% annually over the past 30 years. In comparison, expected annual 10-year returns on the SPX using the same methodology sit at just 3%, which suggests 12% annual outperformance of the IJR for the full decade.
High Real Rates Are A Headwind But IJR Still Set To Outperform Cash And Large Cap Stocks
Historical growth rates are highly unlikely to be repeated. One of the main drivers of per share fundamentals on the S&P600 Small Cap index has been the reduction in share count driven by net buybacks, which has added around 3% annually to returns over the past two decades. With debt ratios at multi-year highs and real yields extremely elevated, we have started to see this trend reverse.
S&P500 Small Cap Price, Market Cap, and Total Share Count (Bloomberg)
Small cap earnings are much more susceptible to economic shocks than large cap earnings, in part due to their higher debt levels and lower profit margins. The combination of high real yields and slowing economic growth therefore poses a risk to earnings. However, it is difficult to see the long-term trend of small cap fundamental outperformance ending any time soon, and the IJR appears to have already priced in severe economic weakness.
For further details see:
IJR: The Lows May Be In For Small Caps