Should Investors be Deterred from Small Caps?

In our latest Wall Street Mood Monitor™, Chief Investment Officer John Riddle, highlights the decidedly negative sentiment on Wall Street as part of our three-factor model of revisions, earnings trends, and correlations. Here, we take a deeper look at revisions, specifically within the small cap universe.

Similar to the broader market, our small cap universe experienced a sharp downturn in sentiment, as measured by net sell-side changes to corporate earnings forecasts. On a quarterly basis, the percentage of upward revisions rose from 45% at the end of March 2017 to a high of 60% one year later. Since the first quarter of 2018, this ratio dropped back below its long-term average.

Should declining analyst sentiment be a deterrent for owning small cap equities? We think not. The chart below shows the quarterly trend in revision activity, since 2008, within our small cap universe. The recent nosedive in sentiment was quick and steep, but its current level is only slightly below the longer-term average. As the chart shows, there have been lengthy periods where sentiment was largely pessimistic, with respect to forward estimate changes. From September 2012 to March 2016, positive sentiment generally hovered at or below the long-term average. During these three and a half years, the cumulative return on the Russell 2000 Index was 39.6%, or 10% annualized.

Source: S&P Global Clarifi; 361 Capital. 361 Capital small cap universe is a subset of the Russell 2000, filtered for analyst coverage, liquidity and price minimums.

Declining sentiment, and equity indices, may be reflective of the current negative beliefs permeating the market. However, the future does not always unfold as we expect. In fact, deteriorating sentiment can be beneficial for future returns since it lowers the bar for companies’ earnings expectations. Thus, the recent resetting of sentiment should not be a reason to be fearful of future returns. In fact, it might be an opportunity to find companies whose expectations have been lowered, yet still can continue to produce strong earnings.

To read more about the backdrop for active management, read our full Wall Street Mood Monitor report >