Analysts earnings estimates for small-cap stocks for the first quarter and full-year 2019 have plummeted at a historic pace since the beginning of the year, with Wall Street now expecting constituents within the small-cap focused Russell 2000 index to enter an earnings recession in the first half of 2019.
The expected earnings recession, popularly defined as two straight quarters of negative earnings growth, threatens to compound the woes that have plagued small-cap stocks in the month of March and could also be a bearish indicator for the broader stock market, analysts and investors tell MarketWatch.
“What really concerns me is the performance of small and mid cap stocks,” Carlos Dominguez, chief investment officer at Element Pointe Advisors said in an interview. That the Russell 2000 RUT, +0.30% remains more than 10% below its August highs is a red flag for the broader market, he added. “Small-caps usually lead in a bull market, but they’re actually leading to the downside,” he added.
Steven DeSanctis, small-and-mid-cap equity strategist at Jefferies warned clients in a Wednesday research note that “it could be a very ugly reporting season” for small-cap stocks given the speed and severity of cuts to earnings per share, or EPS, estimates.
Jefferies
Indeed, revisions for the current quarter have been historically large for small and large-caps alike. Over the past decade, the average reduction to earnings for companies in the Russell 2000 has been 12.2%, while analysts have lowered their estimates for first-quarter earnings by 13.5% since Dec. 31, according to FactSet data.
“There is no question that estimated growth is falling fast across size, sector, and style, as companies have taken a more conservative stance to 2019,” DeSanctis wrote, pointing out that Wall Street expects earnings for Russell 2000 companies to fall by 14.5% in the first quarter and 4.3% in the second quarter. Analysts are still projecting full-year earnings growth, largely on the belief that the U.S. economy will rebound in the last six months of 2019, powering small-cap EPS to a rise of 12.6% in the fourth quarter.
Projected EPS contractions threaten to further buffet the Russell 2000 index, which has fallen 3.1% month-to-date, versus a 0.2% rise for the S&P 500 SPX, +0.67% index.
An important driver of small-cap struggles appears to be rising costs for labor, services and supplies, as projections for revenue growth aren’t falling nearly as fast as profits. Revenue growth for the first quarter is expected to come in at 3.5% for the first quarter and 4.5% for the year.
Eric Marshall, portfolio manager of the Hodges Capital small-cap fund told MarketWatch that he is seeing companies estimate higher overhead costs, as many small-cap companies are reinvesting in their businesses through research and development, new technology or distribution systems. Such behavior would suggest that small-cap stocks are likely to rebound as the benefits of these investment come to fruition. At the same time, Marshall says that “with a tighter labor market, wage rates have come up,” a trend that is bound to trickle down to the bottom line.
Another force holding back the performance of the Russell 2000 is that financial firms make up roughly a quarter of the index, versus 13.3% for the S&P 500, Marshall said. The Federal Reserve’s pivot to extreme dovish policy has hurt bank and financial stocks of late, and the Russell’s bank-heavy composition will likely continue to weigh on the small-cap index relative to the S&P 500 for quarters to come.
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