Small Cap Stocks: Edging Toward a Bear Market

Summary

WSJ Your Money Briefing

Episode: Small Cap Stocks: Edging Toward a Bear Market
Date: December 13, 2018
Host: J.R. Whalen
Guest: Jessica Minton (Wall Street Journal Markets Reporter)

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Episode Overview

This episode of WSJ Your Money Briefing examines the significant drop in small-cap stocks during late 2018 and explores what this movement signals about broader economic trends. WSJ markets reporter Jessica Minton joins host J.R. Whalen to analyze the reasons behind the shift in investor sentiment, the unique vulnerabilities of small-cap companies, and historical lessons for investors.

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Key Discussion Points & Insights

1. Market Context for Small-Cap Stocks (Begin: 00:36)

• Small-Caps' 2018 Trajectory: Early in the year, small-cap stocks were favored as a hedge against trade tensions. By December, however, the Russell 2000 index was down about 17% from its August high.
• Changing Investor Perceptions: Increased volatility and declining investor confidence led to a sharp pullback from small caps.

2. Earnings Projections and Tax Changes (03:17)

• Synchronized Downgrades: "It's something that you don’t tend to see—small-cap stocks and large-cap stocks move in tandem like this." — Jessica Minton [03:22]
• Both groups faced lowered earnings projections going into 2019, largely due to the waning benefits from the 2018 corporate tax cuts.

3. Sensitivity to Debt and Rising Interest Rates (04:00)

• Debt Vulnerability: Small-cap firms are especially sensitive to borrowing costs.
• Federal Reserve Policy: "If borrowing costs are still going up, even if it is at a slower pace, that's going to impact them more than when it comes to larger companies." — Jessica Minton [04:26]
• Changes in Fed policy (potential for a more dovish stance) may relieve some pressure, but the overall higher interest rate environment remains challenging for small caps.

4. Role of the U.S. Dollar and Exposure Differences (04:40)

• Large-Caps vs. Small-Caps: Multinationals in the S&P 500 could benefit from a softer U.S. dollar (making exports cheaper), while small-caps remain more exposed to domestic borrowing costs.

5. Historical Precedent and Economic Warning Signs (05:13)

• Correlation with Economic Cycles: “Small caps are correlated to the rising and falling of an economic tide… before [the 2008 crisis] there were early indicators when you looked at small-cap companies.” — Jessica Minton [05:27]
• Restrained bank lending to small caps was an early warning signal ahead of the 2008 financial crisis.
• While the current decline isn't necessarily a harbinger of crisis, it's an important indicator to monitor.

6. Lessons for Investors (06:17)

• Historical Awareness: "It definitely taught the lesson that it’s important to remember… these smaller names are reliant on capital and the ease and low cost of capital." — Jessica Minton [06:26]
• As interest rates rise from historical lows, small-cap companies must adapt to the new environment.

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Notable Quotes & Memorable Moments

• On Synchronized Selloff:

  "It's something that you don’t tend to see—small-cap stocks and large-cap stocks move in tandem like this."
  — Jessica Minton [03:22]

• On Debt Sensitivity:

  "If borrowing costs are still going up, even if it is at a slower pace, that's going to impact them more than when it comes to larger companies."
  — Jessica Minton [04:26]

• On Small Caps as Economic Signals:

  "Small caps are correlated to the rising and falling of an economic tide… before [the 2008 crisis] there were early indicators when you looked at small cap companies."
  — Jessica Minton [05:27]

• On Investor Caution:

  "It’s good to be mindful of history perhaps repeating itself… Not that it will do it, but it’s good to make sure you see it as a potential."
  — J.R. Whalen & Jessica Minton [06:17–06:25]

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Important Timestamps

• 00:36 — Host introduction and context for the small-cap pullback
• 03:17 — WSJ reporter Jessica Minton joins to explain stock performance factors
• 04:00 — Discussion of small-cap reliance on debt and Fed rate policy
• 05:13 — Lessons from history and economic warning indicators
• 06:17 — Takeaways for investors and historical parallels

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Tone & Takeaways

• Tone: Analytical, measured, and educational, with an undercurrent of cautious watchfulness.
• Main Takeaway: The slide in small-cap stocks is multifaceted, driven by earnings outlooks, rising interest rates, and broader economic signals. While not a standalone harbinger of recession, this trend is a critical piece of the economic puzzle that warrants attention from investors—especially considering lessons learned from past crises.

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For further reading and context, listeners are encouraged to check out Jessica Minton's reporting on WSJ.com.

Transcript

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[J.R. Whalen]

With your Money briefing. I'm J.R. whalen at the Wall Street Journal in New York. Investors ran to small cap stocks during most of 2018, but as of late they've pulled back more than 15%. We'll explain why in a moment, along with what it could be telegraphing about the strength of the economy. First, these money and market stories. You should know US Consumer prices were flat in November, restrained by tumbling oil prices last month. That puts inflation at 2.2%, down from 2.5% in October and 2.9% in July. Now where inflation goes from here is unclear. While trade tariffs with China and rising wages are two factors that would point to higher inflation in the months ahead, some economists feel they could be washed out by a slowdown in in the housing market. The benefits of steadily rising wages and a tight labor market allowing workers to quit and move to another job isn't reaching everyone. In a survey of American workers, 60% say they did not get a pay raise at their current job or did not get a better paying job in the last 12 months. But 91% of those polled say they have the same or greater confidence in the job market than they did a year ago. Now, while several states and some companies have increased their minimum wage, but the federal minimum wage has been $7.25 since 2009. Studies have shown a $15 wage is the minimum amount needed to keep low wage workers out of poverty. And pop star Enrique Iglesias and retired tennis star Anna Kournikova are putting their Miami mansion on the market for $4.85 million. They bought the property in 2015 for just under $2 million. The house is roughly 6,800 square feet, has a large combination dining and living. It also sits on roughly a third of an acre with a swimming pool, a covered terrace and an outdoor kitchen. They built a six bedroom house for Kournikova's grandparents, but once the house was completed, they decided to sell because it was too big. Earlier this year, small cap stocks were the darlings of Wall street, with investors flocking to them. But as is the case with most categories of equities this year, things have been turned on their ear. Wall Street Journal markets reporter Jessica Minton is here to explain why shares of smaller U.S. companies have fallen out of favor with investors. So, Jessica, small cap stocks are down about 17% from their August high. And investors favored them because they were seen as protection against trade tensions. But those trade related fears, they haven't gone away.

[Jessica Minton]

Exactly. And we are in a rare situation where something that we saw earlier this year, we were in a correction around February and March. And it's something that you don't tend to see small cap stocks in larger cap stocks move in tandem like this. And a lot of that's driving is because for one, both large cap and small caps have lower earnings projections going into the new year, especially in the first quarter, because we're not going to see those tax benefits from those corporate tax rates like we did earlier in 2018. So that's why we're seeing a lot of those downgrades there. But that's something both of them are facing right now.

[J.R. Whalen]

And small cap stocks are more sensitive also to corporate debt and borrowing.

[Jessica Minton]

Absolutely. And that's really the key there between the driver of larger cap stocks and smaller cap stocks. If you think about the path the Federal Reserve is on right now, raising interest rates, there are questions going into next week ahead of their meeting about whether they'll be a little bit more dovish or say less aggressive going into next year, which you think would potentially benefit smaller companies. But we're still in a higher rate environment and those companies hold more debt. So if borrowing costs are still going up, even if it is at a slower pace, that's going to impact them more than when it comes to larger companies. And when you look at say the S&P 500, 500 and the amount of multinationals that are in the s and P500 that have exposure overseas, if the Fed begins to be a little bit more dovish next year, that could take some pressure off of the US Dollar, which essentially helps those companies because it makes exports cheaper for foreign buyers. So it's more attractive to them. So it's interesting just looking at the dynamics there because as far as the analysts that I've spoken with, they still think that a more dovish Fed is still more beneficial. When you're looking at those cap companies

[J.R. Whalen]

and there are people you spoke with for your story in the Journal, they feel the decline among small cap stocks is the undercurrent that has triggered the most recent sell off we're seeing.

[Jessica Minton]

It's interesting because there's so many different forces at play right now when you're looking at the Fed, when you're looking at the trade tensions and when you're looking at those smaller companies. But small caps are correlated to the rising and falling of an economic tide. Now, that's not necessarily saying that we're there right now, but if you look at indicators in the past heading into the 2008 financial CRIs, before that, there were early indicators when you looked at small cap companies and a lot of that was because there were signals there that banks were beginning to rein in credit. And when you think of small cap companies and amount of debt they have, that was sort of the first signal. But no one really saw it quite right then. So it's not necessarily saying this is the beginning and we should be panicking right now or anything like that, but it is something to keep in mind because that's an indicator you can look at when it comes to companies like that that are borrowing more heavily than say these larger cap companies.

[J.R. Whalen]

So good to be mindful of history perhaps repeating itself.

[Jessica Minton]

Yes.

[J.R. Whalen]

Not that it will do it, but it's good to make sure you see it as a potential.

[Jessica Minton]

Right. I think it definitely taught the lesson that it's important to remember that some of these smaller names are reliant on capital and the ease and low cost of capital. So as we continue to move away from these historic lows when we're looking at rates, that's something that they're just going to have to get used to in this type of environment that we're in now.

[J.R. Whalen]

Okay. That is Wall Street Journal markets reporter Jessica Menton here in our studio. Jessica, thanks for being with us.

[Jessica Minton]

Thanks for having me.

[J.R. Whalen]

And that's your money briefing. I'm JR Whalen in New York for the Wall Street Journal.

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