On the One Hand, the Russell 2000 Should Outperform, on the Other Hand…
A Goldman Sachs report released Wednesday, June 28 projects that the Russell 2000 should gain 14% over the next 12 months and could outperform the S&P 500 in the coming year. The economic headwinds that companies represented in the index would have to overcome were discussed in the report. Each should come as no surprise. The forecast is based on Goldman’s research using expected economic growth and current valuations.
Based on US economic growth and a model built on initial valuations, the small-cap index should gain 14% over the next 12 months, according to Goldman. This looks even more favorable compared to the reports projection that the S&P 500 is expected to climb 9% over the same period.
The research note said this would mark a position change as the S&P 500 has been outperforming the Russell 2000 Small Cap index.
Goldman outlined three near-term macro headwinds facing the Russell 2000 Index:
Rising Interest Rates
The index is more sensitive to monetary tightening because listed companies tend to have a higher debt burden than the S&P 500. As interest rates continue to rise, the cost of servicing debt could gradually put pressure on small caps, as about one-third of Russell 2000’s debt is floating rate.
This could become a complication through the remainder of the year, as the Federal Reserve has signaled the possibility of two more hikes. For its part, Goldman expects another hike in July, and predicts a cut for 2024.
Economic Development
Compared to the S&P 500, the Russell 2000 is more sensitive to US economic performance, wrote Goldman. Even if a recession has been avoided, small-cap stocks struggle to outperform in the later stages of the business cycle as investors turn to companies with larger balance sheets.
The note recognized another possible bump in the road suggesting it appears that the market has already priced in the GDP forecasts, and growth looks unlikely to pick up any further as long as the Fed continues to tighten to tame inflation.
Sector Composition
Goldman said the Russell 2000’s high exposure to cyclical stocks, regional banks, real estate and biotech makes it more vulnerable to slowing growth, rising rates and the re-emergence of financial stability fears.
This means there could be further cuts in earnings forecasts. The note recognized that while earnings revisions among S&P 500 companies have mostly been flat, Russell 2000 revisions are continuing.
Take Away
Goldman’s basic analysis shows the propensity for the small cap sector to begin to outperform in a big way. As is the case with market forecasters, the story starts out “on the one hand this could happen,” and then transitions with, “but on the other hand…”. It is standard to look out into the future and see where a sector could be headed, but also recognize where there may be trouble along the way.
The report did not lay out a scenario where the report may have underestimated where the Russell Small Cap index may be in 12 months, but with all the less-than-knowns surrounding this year, and an election year, it is safe to presume that the analyst could also have undershot where actual performance will be 12 months into the future.
Managing Editor, Channelchek
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