Welcome to RBC’s Markets in Motion podcast, recorded March 25th, 2024. I’m Lori Calvasina, Head of US Equity Strategy at RBC Capital Markets. Please listen to the end of this podcast for important disclaimers. Two big things you need to know today: First, our work on the R2000 relative to the S&P 600 (sparked by Small Cap PM concerns about low quality) adds to our belief that the US came close to recession in 2022. Second, CFTC buyside positioning in US equity futures rebounded last week ahead of the Fed, highlighting increased risk of a melt-up in the broader US equity market.
If you’d like to hear more, here’s another five minutes. Now, let’s jump into the details.
Starting with Takeaway #1: Our Work on the Russell 2000 Relative to the S&P 600 Adds To Our Belief That The US Came Close To Recession in 2022
We had the pleasure of meeting with a number of Small Cap focused investors last week, who were interested in exploring how the S&P 600 (generally thought of as a higher quality Small Cap benchmark) compares to the R2000 (the index family that most Small Cap active managers benchmark to), particularly in regard to non-earners. The percent of companies with negative EPS is near the high end of its range for the R2000 (39%), but is well below prior peaks for the S&P 600 (16% currently vs. 27%). In the R2000, Health Care and Tech are heavily skewed towards negative earners.
These investors were also preoccupied with whether a fierce low quality rally might be coming to Small Cap. Though actively managed Small Cap funds generally use one of the Russell 2000 indices as their benchmark, the S&P 600 tends to better reflect their investable universe and they tend to underperform when low quality bursts occur. We’ve pointed out that R2000 has seen a few mini bursts of leadership vs. the S&P 600 since May 2022, but these have been mild in terms of magnitude when compared to those seen in late 2002 through early 2004 and in late 2019 through the end of 2020.
We don’t rule out another burst of low quality leadership within Small Cap (i.e., R2000 leadership relative to the S&P 600), but think Small Cap investors should keep a few things in mind. First, though it’s occurred in fits and starts and has been mild in terms of magnitude, the R2000 has technically beaten the S&P 600 since May 2022. The duration in terms of time is similar to the low quality trades seen coming out of the post-Tech bubble normalization period of 2002-early 2004 and the immediate pre- and post-COVID time period of late 2019 to late 2020.
Second, the S&P 600 has strongly outperformed the R2000 over time, a testament to the longer-term appeal of high quality in Small Cap.
Third, the valuation profiles of the 2000 and 600 are fairly similar, at least among profitable companies. R2000 is a little lower on equal weighted median P/E, but the S&P 600 is a little lower on a market cap weighted median P/E. A case can be made for either index on valuation.
Over the years, we’ve come to believe that Small Caps have important lessons for all US equity investors whether they can buy them or not, and this exercise was no different. On the broader market debate, two data points stand out. First, low quality leadership within Small Cap tends to be seen coming out of recessions and other crises and has been seen since 2022. Second, our review of the various P/E multiples of the S&P 600 and Russell 2000 highlights how both indices, which are mostly domestic and are seen as US economic bellwethers, were in line with typical recessionary lows in 2022. We see both the slight leadership seen in the R2000 vs. the S&P 600 since mid-2022 and the depths to which Small Cap P/Es fell in 2022 as one of a number of items on our growing list of data points suggesting the US economy came close to recession in 2022, and that we are in the midst of one of the most odd and confusing recoveries in US equity market history.
Moving on to Takeaway #2: CFTC Buyside Positioning In US Equity Futures Rebounded Ahead of the Fed
We’ve been highlighting for some time how US equity market sentiment has look stretched on a variety of indicators (AAII net bulls, CFTC buyside positioning in US equity futures, the University of Michigan survey’s questions on the outlook for stock prices, and the Fed Flow of Funds data on US equities as a percent of financial assets). Last week, we highlighted how aggregate buyside positioning in US equity futures on CFTC’s data had started to move lower, driven by declines in S&P 500 and Nasdaq 100 futures contracts. It appeared that the short-term pullback we’ve been looking for in the US equity market for the past months might finally be materializing.
However, in Friday’s update (which pulls in data from the preceding Tuesday’s close), we were surprised to discover that buyside CFTC positioning in US equity futures reversed course and moved up.
Both S&P 500 and Nasdaq 100 positioning popped, though only the former recaptured and surpassed previous highs.
Meanwhile, the resilience we had been seeing in Russell 2000 futures positioning fell by the wayside.
What does this mean for the direction of the US equity market from here? It’s tough to say. We continue to see sentiment as stretched and think a US equity market pullback is overdue. But the risks of a melt-up, particularly given the dovish Fed meeting and rapid increases to 2024 GDP that are underway, have admittedly grown. We’re keeping a close eye on the AAII data set where net bullishness has been roughly one standard deviation above its long-term average, but not two standard deviations, which can occasionally mark the top. We are starting to worry again that we’ll get there before this rally takes a breather. While this is good news for the US equity market in the short term, it’s bad news over the longer term as the S&P 500 tends to fall on a 12-month forward basis when that plus the two-standard-deviation threshold is reached.
That’s all for now. Thanks for listening. And be sure to reach out to your RBC representative with any questions.