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After Wall St.’s steep decline the week before, U.S. small caps lured investors with cheap valuations

After Wall St.'s steep decline the week before, U.S. small caps lured investors with cheap valuations
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The floor of the New York Stock Exchange (NYSE) is seen after the close of trading in New York, U.S., March 18, 2020. REUTERS/Lucas Jackson

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NEW YORK, July 29 (Reuters) – Shares of smaller U.S. companies are outpacing a rally in the broader equity market as they lure investors to snap up cheaply valued stocks and those who bet they are already in an economic downturn.

Small-cap Russell 2000 (.RUT) The index jumped 10.4% in July, versus a 9.1% gain for the benchmark S&P 500. (.SPX)Its biggest percentage-point outperformance on a monthly basis since February.

Small caps are more domestically oriented, less profitable and carry a heavier debt load than their larger counterparts, often putting them in the firing line when economic concerns persist and markets become volatile.

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This year was no exception: The Russell 2000 is down 16% in 2022 despite a July rebound, compared with the S&P 500’s 13.3% drop, as the Federal Reserve tightened monetary policy faster than expected to fight red-hot inflation and reduced appetite for risk. . the market

The small-cap index is now the cheapest compared to the large-cap Russell 1000 (.RUI) Since March 2020, some bargains have caught the eye of investors, according to Jefferies data.

“The small-cap space had a lot of losses,” said Francis Gannon, co-chief investment officer at Royce Investment Partners. “It’s one of the cheapest parts of the U.S. market.”

Gannon continues to increase positions in small caps, focusing on industrial, materials and technology companies in the space.

Some investors also believe that the prices of small caps — which are seen as more in tune with the economy’s fluctuations — may already be reflecting a potential recession, limiting their downside if forecasts of one materialize.

Data this week showed that US gross domestic product contracted for the second straight quarter, meeting the oft-cited definition of a recession. Read more However, the National Bureau of Economic Research, the official arbiter of the business cycle, has yet to declare a recession, and Fed Chair Jerome Powell said this week that the economy is unlikely to be one, citing a strong employment backdrop.

RBC Capital Markets analysts said in a report earlier in July that small caps appear to be “already suffering from considerable economic distress.”

“Downturns tend to be good buying opportunities for small caps,” they added.

The bank also noted that the Russell 2000’s forward price-to-earnings ratio traded in the 11-13 times range, “which marks its bottom.”

“Stocks at the bottom of the market cap spectrum are closer to being priced into recessions than their large cap peers,” Citi US Equity strategists wrote earlier this week.

Not everyone is convinced that it’s time to buy small caps. If inflation persists and the Fed is forced to raise rates more aggressively than expected, causing more pain in the economy, appetite for smaller company shares could quickly diminish.

The central bank has already raised interest rates by 2.25 percentage points this year as it battles the worst inflation in four decades, but Powell offered little concrete guidance on what to expect next during his press conference after Wednesday’s Fed meeting. Read more

“Although the market is (already) in a mild bearish mood, some more disappointing economic news could come,” said Angelo Korkafus, an investment strategist at Edward Jones, who recommends clients “underweight” small caps for now.

The economy’s strength will face a key test next week, when the US jobs report for July is released. Economic data over the next two months is expected to be particularly important to market sentiment in signaling the Fed’s next move.

Analysts at the Wells Fargo Investment Institute said smaller companies will be challenged to maintain profitability and healthy cash positions as the economy slows. The agency expects the US economy to remain in recession in the second half of 2022 and into early 2023.

“We don’t think small caps have the legs for this move,” said Sameer Samana, senior global market strategist at the Wells Institute.

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Reporting by Lewis Krauskopf and David Randall in New York Editing by Matthew Lewis

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