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What is next for small caps?

The past year posed considerable challenges for equity investors, including runaway inflation, a rising interest rate environment, geopolitical tensions,…



The past year posed considerable challenges for equity investors, including runaway inflation, a rising interest rate environment, geopolitical tensions, and the lingering effects of the pandemic. The confluence of these headwinds – and a lack of positive catalysts – roiled market sentiment, resulting in most equity analysts adjusting their expectations for corporate earnings growth substantially lower.

Though many of last year’s issues remain unresolved, we believe there are reasons for investors to be optimistic in 2023. Despite the uncertain economic outlook, we see silver linings in the small cap universe, particularly in many higher-quality businesses that have displayed fiscal discipline and continue to grow even in a challenging environment. Below, we explore some forces we believe could propel small caps in the year ahead.

Planting the seeds for sustained small cap outperformance?

The past decade was marked by extreme leadership in large cap growth. To put it in context, as of the year ending 2022, the Russell 2000 Growth Index – a measure of small cap growth stocks – had underperformed the Russell 1000 Growth – a measure of large cap growth stocks – by nearly -5 per cent annualized over the past 10 years.

However, we’ve observed over extended periods that leadership between small and large caps tends to be a cyclical phenomenon that can persist anywhere from a few years to over a decade. For instance, the decade prior (12/31/2002 through 12/31/2012) saw small cap growth outperform large cap growth by +2.3 per cent annualized as seen below.

Small and large caps trade leadership over time

Source: Polen Capital, Bloomberg. “2013-2022” shows performance for the respective indices over the most recent decade ended 12/31/2022. “2003-2012” shows performance for the same indices over the prior decade, ending 12/31/2012.

With the new year now upon us, a fair question would be, “What signs are you seeing that could indicate the cycle is shifting from large cap leadership to small caps leading the way?” To that, we would suggest three potential catalysts:

  1. Throughout history, bear market recoveries have tended to provide the backdrop for a sustained run of outperformance in small caps.
  2. Small caps are as inexpensive on an absolute and relative basis (versus large caps) as we’ve seen in a long time, setting the stage for higher expected returns going forward.
  3. An environment of high and moderating inflation—such as the one we are in now— tends to provide a powerful tailwind to small cap returns.

Small cap leadership out of bear market bottoms

For various reasons, small caps have tended to be the first in line to sell off when concerns about slower economic growth begin to intensify. The logic goes that small caps are usually more cyclically exposed and are more sensitive to an increase in interest rates or a decrease in consumer spending.

For many companies, this is a legitimate risk, and the ensuing decline in share prices may be appropriate given the deteriorating fundamental picture. However, some investors often throw the proverbial baby out with the bathwater during periods of turbulence, providing more discerning investors the opportunity to become owners of high-quality companies where the share price has more than discounted any weakness in the underlying fundamentals.

The events of last year are a great illustration of this. Through the first five months of 2022, the Russell 2000 Growth underperformed the Russell 1000 Growth by -3.0 per cent as markets grappled with the prospect that the Fed’s efforts to combat rising inflation could tip the U.S. into recession. The Russell 2000 Growth was -24.8 per cent as of 5/31/2022, with a quarter of index constituents down -50 per cent or more over this timeframe.

However, by mid-June, the Russell 2000 Growth had bottomed while the Russell 1000 Growth continued to move lower. In real time, it’s hard to attribute a cause for this bottoming in small caps. Still, it is consistent with history in two respects: 1) stocks tend to bottom before economic data bottoms, and 2) small caps tend to lead in bear market recoveries. From mid-June through the end of 2022, the Russell 2000 Growth was up +11.0 per cent, outperforming the Russell 1000 Growth by +8.2 per cent as shown below.

Performance since 2022 small cap bottoms (6/16/2022)

Source: Polen Capital, Bloomberg. Chart shows performance for the respective indices from the Russell 2000 Growth low on 6/16/2022 through 12/31/2022.

On this latter point, the chart below illustrates this phenomenon by displaying a few notable bear markets over the past few decades. Specifically, in the year following a market bottom, small caps have, on average, delivered a +92 per cent total return, outperforming large caps by +29 per cent.

12-Month performance from bear market troughs (2000)

Source: Polen Capital, Bloomberg. Bear market troughs are identified using a measure of the broad U.S. stock market, the S&P 500 Index. Returns are given for the respective indices over the ensuing year from the bear market trough. “Oct-2002” bottom was on 10/9/2002, following the Dotcom Bubble; “March-2009” bottom was on 3/9/2009, following the Global Financial Crisis; “March-2020” bottom was on 3/23/2020, amidst the COVID-19 pandemic.

Trading at a discount: valuations at multi-decade lows

After underperforming their large-cap peers over the last decade, small caps appear undervalued compared to history. Relative to large caps, recessionary fears have had a more pronounced impact on the valuations of small companies, which seem to have baked in gloomier outcomes for the year ahead and are presently trading at a discount.

As noted earlier, when negative sentiment clouds investor judgment, it is not uncommon to see some investors rush for the exit, selling both high-quality and low-quality stocks indiscriminately. Given that “growth” stocks tend to have a more significant portion of their cash flows out into the future as compared to “value” stocks, they are more sensitive to changes in interest rates and, as such, have felt the most acute impact in their stock prices over the past year.

The silver lining is that, in our view, the selloff has created compelling opportunities. Over nearly 30 years of data, rarely have small caps been this inexpensive. In absolute terms, you must go back to the Global Financial Crisis timeframe (2008-2009) and the post-Dotcom Bubble era to see comparable valuations.1 In relative terms versus large caps, small caps have only been this inexpensive 7 per cent of the time over the past 28 years. While valuation is not a precise mechanism around when to time an allocation, it shows that future expected returns for small caps are as attractive as we have seen for long-term investors looking to add to their portfolios opportunistically.

Russell 2000 growth forward 12-month P/E

Source: Polen Capital, Bloomberg. Data shown from 3/31/1995 (earliest data available in Bloomberg) through 12/31/2022. Shows P/E ratio based on Forward 12-month Bloomberg consensus estimates, which are subject to revision over time. The green line indicates the median Forward 12-month P/E over the period shown.

Small Caps and Monetary Policy

While valuations are at some of the most attractive levels we have seen in years, there are other reasons why we maintain a constructive view of the asset class. In early 2022, the Fed quickly changed its stance from inflation being transitory to be more persistent. In short order, the Fed embarked on a historically rapid rate hike cycle that saw the Federal Funds Target Rate go from near zero at the beginning of the year to 4.5 per cent by the end of the year. This had an outsized impact on growth stocks given their “long duration” nature, with cash flows out into the future being discounted back at higher rates.

But as we got into the middle part of the year, the consumer price index (“CPI”) peaked at +9.1 per cent year-over-year in June 2022 and started to decline at the end of the year. As the year progressed, the consensus shifted from “we’re going into a deep recession” to “perhaps this will be a mild recession or even a soft landing.” While it’s impossible to predict the macroeconomic outlook, small caps tend to do best in an environment of high but falling inflation, as our analysis below demonstrates.

Going back to the inception of the Russell indices at the end of 1978, we looked at four different market environments:

  1. Inflation above 3 per cent and rising year-over-year
  2. Inflation above 3 per cent and falling year-over-year
  3. Inflation below 3 per cent and rising year-over-year
  4. Inflation below 3 per cent and falling year-over-year

It’s in the last bucket (high but falling inflation) that small caps have tended to do best in absolute and relative terms.

Russell 2000 Growth Average Absolute Returns by Macro Environment

  <3% CPI >3% CPI
Rising YoY Inflation 14.00% 0.90%
Falling YoY Inflation 11.60% 27.20%

Russell 2000 Growth Average Relative Returns vs. Russell 1000 Growth, by Macro Environment

  <3% CPI >3% CPI
Rising YoY Inflation -0.80% -5.10%
Falling YoY Inflation -1.60% 6.30%

Source: Polen Capital, Bloomberg. Data is shown from the inception of the Russell style indices (12/31/1978) through 12/31/2022. Methodology: 3 per cent is used as a dividing line for high and low inflation. Rising/Falling YoY Inflation is measured by looking at CPI for a given year and how it compares to the previous year. For example, 2022 would count as a high (>3 per cent) and rising YoY inflation year, and the calendar year return would influence the upper right-hand corner of the table. The observations are summarized for each box in the table with a straight average of the calendar year’s performance. Sticking with the high and rising example, there are 12 years since 1978 where this has been the case. The average of those years shows the Russell 2000 Growth delivered +0.9 per cent absolute returns on average.

Could quality be the key to small cap investing?

Conventional wisdom suggests that small caps can be inherently more volatile than large caps during periods of slower economic growth and tighter financial conditions. While there is some truth behind this generalization, painting every small cap company with the same brush can be misleading. Though we agree that certain companies—mainly those with unprofitable business models, high debt levels, and low returns on invested capital—could be susceptible to headwinds during tough times, high-quality small caps might survive and grow even in the face of adversity.

To this point, many high-quality small cap businesses posted surprisingly robust earnings results last year, showcasing fiscal discipline in managing their expenses and leaning into pricing power where possible. Additionally, we believe that high-quality companies with durable economic moats have more financial flexibility and pricing power, which helps dampen the impact of external forces.

In the case of many innovative small caps, we believe developing disruptive technologies and opening new markets are some examples of more critical determining factors of their future long-term success. As we move forward, we believe we will see an increasing dispersion in the performance of high-quality and low-quality businesses, given a more normalized interest rate landscape that should return the focus to company-specific drivers.

Investor key takeaways

Going forward, the severity of an impending recession, the path of inflation and interest rates, and geopolitics will continue to influence markets. While the market’s risk appetite may turn quickly or resume slowly, we believe that investing in small caps today may give investors with a long-term horizon an exceptional opportunity to own some of tomorrow’s most successful businesses at attractive prices. To recap:

  • Looking through history, bear market recoveries have tended to provide the backdrop for a sustained run of outperformance in small caps.
  • Small caps are historically inexpensive on an absolute and relative basis (versus large caps), setting the stage for higher expected returns.
  • An environment of high and falling inflation—such as the one we are in now—tends to provide a powerful tailwind to small cap returns.

American investor Shelby Cullom Davis once said:

“You make most of your money in a bear market; you just don’t know it at the time.

Despite the bumpy near-term outlook, we believe that the underlying growth story in small caps remains intact, and the investment opportunity for the asset class is as attractive as we have seen in many years.

1 The Global Financial Crisis (“GFC”) refers to the period of extreme stress in global financial markets and banking systems between mid-2007 and early 2009. During this period, the S&P peaked in Oct-2007 and bottomed in Mar-2009. The Dotcom Bubble was a rapid rise in U.S. technology stock equity valuations fueled by investments in Internet-based companies in the late 1990s. During this period, the S&P peaked in Mar-2000 and bottomed in Oct-2002.

This information is provided for illustrative purposes only. Opinions and views expressed constitute the judgment of Polen Capital as of February 2023 may involve a number of assumptions and estimates which are not guaranteed and are subject to change without notice or update. Although the information and any opinions or views given have been obtained from or based on sources believed to be reliable, no warranty or representation is made as to their correctness, completeness or accuracy. Opinions, estimates, forecasts, and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice, including any forward-looking estimates or statements which are based on certain expectations and assumptions. The views and strategies described may not be suitable for all clients. This document does not identify all the risks (direct or indirect) or other considerations which might be material to you when entering any financial transaction.

The information in this document has been prepared without taking into account individual objectives, financial situations or needs. It should not be relied upon as a substitute for financial or other specialist advice. This document is provided on a confidential basis for informational purposes only and may not be reproduced in any form or transmitted to any person without authorization from Polen Capital Management.

The volatility and other material characteristics of the indices referenced may be materially different from the performance achieved by an individual investor. In addition, an investor’s holdings may be materially different from those within the index. Indices are unmanaged and one cannot invest directly in an index. The performance of an index does not reflect any transaction costs, management fees, or taxes.

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February Employment Situation

By Paul Gomme and Peter Rupert The establishment data from the BLS showed a 275,000 increase in payroll employment for February, outpacing the 230,000…



By Paul Gomme and Peter Rupert

The establishment data from the BLS showed a 275,000 increase in payroll employment for February, outpacing the 230,000 average over the previous 12 months. The payroll data for January and December were revised down by a total of 167,000. The private sector added 223,000 new jobs, the largest gain since May of last year.

Temporary help services employment continues a steep decline after a sharp post-pandemic rise.

Average hours of work increased from 34.2 to 34.3. The increase, along with the 223,000 private employment increase led to a hefty increase in total hours of 5.6% at an annualized rate, also the largest increase since May of last year.

The establishment report, once again, beat “expectations;” the WSJ survey of economists was 198,000. Other than the downward revisions, mentioned above, another bit of negative news was a smallish increase in wage growth, from $34.52 to $34.57.

The household survey shows that the labor force increased 150,000, a drop in employment of 184,000 and an increase in the number of unemployed persons of 334,000. The labor force participation rate held steady at 62.5, the employment to population ratio decreased from 60.2 to 60.1 and the unemployment rate increased from 3.66 to 3.86. Remember that the unemployment rate is the number of unemployed relative to the labor force (the number employed plus the number unemployed). Consequently, the unemployment rate can go up if the number of unemployed rises holding fixed the labor force, or if the labor force shrinks holding the number unemployed unchanged. An increase in the unemployment rate is not necessarily a bad thing: it may reflect a strong labor market drawing “marginally attached” individuals from outside the labor force. Indeed, there was a 96,000 decline in those workers.

Earlier in the week, the BLS announced JOLTS (Job Openings and Labor Turnover Survey) data for January. There isn’t much to report here as the job openings changed little at 8.9 million, the number of hires and total separations were little changed at 5.7 million and 5.3 million, respectively.

As has been the case for the last couple of years, the number of job openings remains higher than the number of unemployed persons.

Also earlier in the week the BLS announced that productivity increased 3.2% in the 4th quarter with output rising 3.5% and hours of work rising 0.3%.

The bottom line is that the labor market continues its surprisingly (to some) strong performance, once again proving stronger than many had expected. This strength makes it difficult to justify any interest rate cuts soon, particularly given the recent inflation spike.

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Mortgage rates fall as labor market normalizes

Jobless claims show an expanding economy. We will only be in a recession once jobless claims exceed 323,000 on a four-week moving average.



Everyone was waiting to see if this week’s jobs report would send mortgage rates higher, which is what happened last month. Instead, the 10-year yield had a muted response after the headline number beat estimates, but we have negative job revisions from previous months. The Federal Reserve’s fear of wage growth spiraling out of control hasn’t materialized for over two years now and the unemployment rate ticked up to 3.9%. For now, we can say the labor market isn’t tight anymore, but it’s also not breaking.

The key labor data line in this expansion is the weekly jobless claims report. Jobless claims show an expanding economy that has not lost jobs yet. We will only be in a recession once jobless claims exceed 323,000 on a four-week moving average.

From the Fed: In the week ended March 2, initial claims for unemployment insurance benefits were flat, at 217,000. The four-week moving average declined slightly by 750, to 212,250

Below is an explanation of how we got here with the labor market, which all started during COVID-19.

1. I wrote the COVID-19 recovery model on April 7, 2020, and retired it on Dec. 9, 2020. By that time, the upfront recovery phase was done, and I needed to model out when we would get the jobs lost back.

2. Early in the labor market recovery, when we saw weaker job reports, I doubled and tripled down on my assertion that job openings would get to 10 million in this recovery. Job openings rose as high as to 12 million and are currently over 9 million. Even with the massive miss on a job report in May 2021, I didn’t waver.

Currently, the jobs openings, quit percentage and hires data are below pre-COVID-19 levels, which means the labor market isn’t as tight as it once was, and this is why the employment cost index has been slowing data to move along the quits percentage.  


3. I wrote that we should get back all the jobs lost to COVID-19 by September of 2022. At the time this would be a speedy labor market recovery, and it happened on schedule, too

Total employment data

4. This is the key one for right now: If COVID-19 hadn’t happened, we would have between 157 million and 159 million jobs today, which would have been in line with the job growth rate in February 2020. Today, we are at 157,808,000. This is important because job growth should be cooling down now. We are more in line with where the labor market should be when averaging 140K-165K monthly. So for now, the fact that we aren’t trending between 140K-165K means we still have a bit more recovery kick left before we get down to those levels. 

From BLS: Total nonfarm payroll employment rose by 275,000 in February, and the unemployment rate increased to 3.9 percent, the U.S. Bureau of Labor Statistics reported today. Job gains occurred in health care, in government, in food services and drinking places, in social assistance, and in transportation and warehousing.

Here are the jobs that were created and lost in the previous month:


In this jobs report, the unemployment rate for education levels looks like this:

  • Less than a high school diploma: 6.1%
  • High school graduate and no college: 4.2%
  • Some college or associate degree: 3.1%
  • Bachelor’s degree or higher: 2.2%

Today’s report has continued the trend of the labor data beating my expectations, only because I am looking for the jobs data to slow down to a level of 140K-165K, which hasn’t happened yet. I wouldn’t categorize the labor market as being tight anymore because of the quits ratio and the hires data in the job openings report. This also shows itself in the employment cost index as well. These are key data lines for the Fed and the reason we are going to see three rate cuts this year.

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Inside The Most Ridiculous Jobs Report In History: Record 1.2 Million Immigrant Jobs Added In One Month

Inside The Most Ridiculous Jobs Report In History: Record 1.2 Million Immigrant Jobs Added In One Month

Last month we though that the January…



Inside The Most Ridiculous Jobs Report In History: Record 1.2 Million Immigrant Jobs Added In One Month

Last month we though that the January jobs report was the "most ridiculous in recent history" but, boy, were we wrong because this morning the Biden department of goalseeked propaganda (aka BLS) published the February jobs report, and holy crap was that something else. Even Goebbels would blush. 

What happened? Let's take a closer look.

On the surface, it was (almost) another blockbuster jobs report, certainly one which nobody expected, or rather just one bank out of 76 expected. Starting at the top, the BLS reported that in February the US unexpectedly added 275K jobs, with just one research analyst (from Dai-Ichi Research) expecting a higher number.

Some context: after last month's record 4-sigma beat, today's print was "only" 3 sigma higher than estimates. Needless to say, two multiple sigma beats in a row used to only happen in the USSR... and now in the US, apparently.

Before we go any further, a quick note on what last month we said was "the most ridiculous jobs report in recent history": it appears the BLS read our comments and decided to stop beclowing itself. It did that by slashing last month's ridiculous print by over a third, and revising what was originally reported as a massive 353K beat to just 229K,  a 124K revision, which was the biggest one-month negative revision in two years!

Of course, that does not mean that this month's jobs print won't be revised lower: it will be, and not just that month but every other month until the November election because that's the only tool left in the Biden admin's box: pretend the economic and jobs are strong, then revise them sharply lower the next month, something we pointed out first last summer and which has not failed to disappoint once.

To be fair, not every aspect of the jobs report was stellar (after all, the BLS had to give it some vague credibility). Take the unemployment rate, after flatlining between 3.4% and 3.8% for two years - and thus denying expectations from Sahm's Rule that a recession may have already started - in February the unemployment rate unexpectedly jumped to 3.9%, the highest since February 2022 (with Black unemployment spiking by 0.3% to 5.6%, an indicator which the Biden admin will quickly slam as widespread economic racism or something).

And then there were average hourly earnings, which after surging 0.6% MoM in January (since revised to 0.5%) and spooking markets that wage growth is so hot, the Fed will have no choice but to delay cuts, in February the number tumbled to just 0.1%, the lowest in two years...

... for one simple reason: last month's average wage surge had nothing to do with actual wages, and everything to do with the BLS estimate of hours worked (which is the denominator in the average wage calculation) which last month tumbled to just 34.1 (we were led to believe) the lowest since the covid pandemic...

... but has since been revised higher while the February print rose even more, to 34.3, hence why the latest average wage data was once again a product not of wages going up, but of how long Americans worked in any weekly period, in this case higher from 34.1 to 34.3, an increase which has a major impact on the average calculation.

While the above data points were examples of some latent weakness in the latest report, perhaps meant to give it a sheen of veracity, it was everything else in the report that was a problem starting with the BLS's latest choice of seasonal adjustments (after last month's wholesale revision), which have gone from merely laughable to full clownshow, as the following comparison between the monthly change in BLS and ADP payrolls shows. The trend is clear: the Biden admin numbers are now clearly rising even as the impartial ADP (which directly logs employment numbers at the company level and is far more accurate), shows an accelerating slowdown.

But it's more than just the Biden admin hanging its "success" on seasonal adjustments: when one digs deeper inside the jobs report, all sorts of ugly things emerge... such as the growing unprecedented divergence between the Establishment (payrolls) survey and much more accurate Household (actual employment) survey. To wit, while in January the BLS claims 275K payrolls were added, the Household survey found that the number of actually employed workers dropped for the third straight month (and 4 in the past 5), this time by 184K (from 161.152K to 160.968K).

This means that while the Payrolls series hits new all time highs every month since December 2020 (when according to the BLS the US had its last month of payrolls losses), the level of Employment has not budged in the past year. Worse, as shown in the chart below, such a gaping divergence has opened between the two series in the past 4 years, that the number of Employed workers would need to soar by 9 million (!) to catch up to what Payrolls claims is the employment situation.

There's more: shifting from a quantitative to a qualitative assessment, reveals just how ugly the composition of "new jobs" has been. Consider this: the BLS reports that in February 2024, the US had 132.9 million full-time jobs and 27.9 million part-time jobs. Well, that's great... until you look back one year and find that in February 2023 the US had 133.2 million full-time jobs, or more than it does one year later! And yes, all the job growth since then has been in part-time jobs, which have increased by 921K since February 2023 (from 27.020 million to 27.941 million).

Here is a summary of the labor composition in the past year: all the new jobs have been part-time jobs!

But wait there's even more, because now that the primary season is over and we enter the heart of election season and political talking points will be thrown around left and right, especially in the context of the immigration crisis created intentionally by the Biden administration which is hoping to import millions of new Democratic voters (maybe the US can hold the presidential election in Honduras or Guatemala, after all it is their citizens that will be illegally casting the key votes in November), what we find is that in February, the number of native-born workers tumbled again, sliding by a massive 560K to just 129.807 million. Add to this the December data, and we get a near-record 2.4 million plunge in native-born workers in just the past 3 months (only the covid crash was worse)!

The offset? A record 1.2 million foreign-born (read immigrants, both legal and illegal but mostly illegal) workers added in February!

Said otherwise, not only has all job creation in the past 6 years has been exclusively for foreign-born workers...

Source: St Louis Fed FRED Native Born and Foreign Born

... but there has been zero job-creation for native born workers since June 2018!

This is a huge issue - especially at a time of an illegal alien flood at the southwest border...

... and is about to become a huge political scandal, because once the inevitable recession finally hits, there will be millions of furious unemployed Americans demanding a more accurate explanation for what happened - i.e., the illegal immigration floodgates that were opened by the Biden admin.

Which is also why Biden's handlers will do everything in their power to insure there is no official recession before November... and why after the election is over, all economic hell will finally break loose. Until then, however, expect the jobs numbers to get even more ridiculous.

Tyler Durden Fri, 03/08/2024 - 13:30

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