(Bloomberg) -- Shares of small US companies, one of the riskiest areas of the stock market, are striking a worrisome note for a vital part of the country’s economy.
The Russell 2000 Index is solidly in correction territory, down 16% from its peak in 2021, with companies facing uncertain demand as businesses weigh the fallout of Trump administration’s trade policies. The group that relies on domestic sales for 77% of its revenue, according to Jefferies, is often seen as a harbinger of stress in the economy. While small caps aren’t signaling a recession yet, there are other reasons for concern.
These companies’ valuation, as measured by small caps’ forward price-to-earnings multiple, is positively correlated with the Institute for Supply Management’s monthly manufacturing index, data from Bank of America Corp. show, meaning they tend to move in the same direction. And today’s values are flashing a familiar warning for the nation’s manufacturing sector.
The current price-to-earnings multiple of the group is implying an ISM reading of 47, the bank’s strategist said. Numbers below 50 denote a contraction. The reading has been above that level for the the past two months, after languishing under 50 from late 2022 through December.
“Small caps are discounting a continued (mild) manufacturing recession,” BofA strategists led by Jill Carey Hall wrote in a note to clients last week.
Investors might also be reminded of the trade turmoil of Donald Trump’s first term, when US factory activity declined and manufacturing slumped in the second half of 2019, after the rollout of steel and aluminum tariffs the year before.
It’s a dynamic that stands to gain more attention as investors fret over whether the economy is losing steam at a time when inflation stays sticky, a scenario known as stagflation that may make it difficult for the Federal Reserve to respond with policy measures.
On Monday, data on manufacturing activity in the New York region showed a decline in March as new orders, shipments, and employment contracted. Price indicators climbed for a third-consecutive month. At the same time, industrial production data for February came in better than expected on Tuesday.
The Russell 2000 was one of the biggest gainers among equities after President Donald Trump won the US election in November. Investors piled into the group, expecting it would do well in a protectionist regime given the companies’ largely domestic operations. Deregulation and lower interest rates were also expected to give them a big boost.
But that rally faded as doubts emerged about the impact of tariffs and as worries grew that the US economy has started to cool. Smaller companies — typically less profitable and with greater debt loads than their larger counterparts — are usually the first to feel the pinch.
Last week, Bank of America’s clients sold small-cap ETFs even as they were net buyers of US equities for a seventh-straight week. The selling in small caps was so severe that it marked the biggest outflow in the space since July 2022, strategists led by Carey Hall wrote in a note on Monday.
Still, some strategists say small-caps’ volatility may detract from their roles as a recession predictor, and that the recent slide is just part of the overall angst gripping the market lately, amid doubts about US trade policy, geopolitics and the economy. But others say this is the kind of environment in which they’re most useful to watch.
“Small caps do tend to be the canary in the coal mine, and right now the canary is coughing and soon might keel over,” said Sam Stovall, chief investment strategist at CFRA. “This higher-volatility group is likely to surrender its gains more quickly than large caps in the face of a recession.“
