The Sum of All Fears?

David Dineen, Chief Investment Officer, Global Small Cap
May 9, 2022

Global equity markets experienced a rocky start to the year, with many indices down double-digits through April.  Equity market returns have been buffeted by a cocktail of persistent negative inflation surprises, a growing chorus of hawkish central banks, slowing economic momentum and increased geopolitical risk in the aftermath of Russia’s invasion of Ukraine.  At the risk of oversimplification, the market narrative has shifted from looking toward a post-COVID-19 recovery and normalization to pricing the probability of a recession.  Ironically, the “honeymoon” of the ebbing of the COVID-19 numbers and signs that economic activity is returning to pre-COVID-19 levels has proved to be short-lived.  This pronounced pivot in the equity market narrative has caused a dramatic re-pricing of risk, with investors’ dwindling risk appetite driving negative equity market returns, particularly in small caps.  Through April, the S&P 500 Index (S&P 500) is down 13.3%, while the Russell 2000 Index (Russell 2000) has shed 16.9%.  We view this largely as a reflection of “risk-off” conditions permeating market psychology.

Although we understand the market’s skittishness, we have a constructive stance toward current opportunities in the small cap investment universe.  Our positive view is anchored by current valuation levels and earnings trends.  Although neither is likely to be a short-term catalyst for improved performance, we believe that the investment pendulum has swung too hard in favor of risk aversion, as evidenced by the elevated reading of the VIX (a measure of the estimated implied volatility for the S&P 500), which is currently pricing approximately 30% annualized volatility for the index.  Historically, these levels of volatility are somewhat of an outlier and approximately 50% higher than the 30-year average of 19.75% as volatility implies.  Mean reversion to historical levels suggests conditions are falling into place for a shift toward small cap stocks outperforming larger caps as volatility abates.

On the earnings front, the recent earnings data favors the Russell 2000, which recently saw estimates rise much faster than the S&P 500, which has experienced more muted activity.  The fact that large cap is outperforming while its smaller cap brethren are seeing more robust positive earnings revisions does not seem sustainable to us.  Additionally, our analysis shows valuations have compressed more dramatically for small caps versus large caps.  The Russell 2000’s current price/earnings multiple of 13x is close to its December 2018 low; meanwhile, the S&P 500’s price/earnings multiple is trading around 20x, which is four multiple points higher than its 2018 trough.   Although relative and historical cheapness is not a catalyst, we believe that once sentiment recovers, small caps may be poised to outperform.

Although sentiment remains negative, we would argue that now is the time to remain disciplined and lean into your investment process as we believe we could see an equity market recovery in the back half of 2022.


The views expressed are those of Spouting Rock Asset Management as of May 4, 2022, and are not intended as investment advice or recommendation. For informational purposes only. Investments are subject to market risk, including the loss of principal. Past performance does not guarantee future results. There can be no assurances that any of the trends described will continue or will not reverse. Past events and trends do not imply, predict or guarantee, and are not necessarily indicative of future events or results. Investors cannot invest directly in an index.

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