When It Comes to Recession Protection, Small Could Be Big | ETF Trends

While employment data suggest otherwise, there are some signs the U.S. economy is slowing and there’s ongoing debate regarding the Federal Reserve’s ability to engineer a “soft landing.” That is to say, many market participants are concerned a recession will hit the world’s largest economy later this year or in early 2024.

Whether or not that scenario arrives remains to be seen, but investors can take preventative measures, including embracing small-cap equities. Perhaps to the surprise of novice investors, smaller stocks have a propensity for being somewhat durable in slack economic environments.

That could spell opportunity with exchange traded funds such as the Invesco NASDAQ Future Gen 200 ETF (QQQS). QQQS is home to 200 stocks, more than 94% of which are considered small-caps. That doesn’t imply excellent performance assuming a recession arrives, but it could be a sign of “less bad” during rough economic times.

“Investing in small caps during recessions has generated superior investment returns, according to our back-testing of the data to the late 1980s,” according to Schroders’ research. “This near 40-year period encompasses numerous recessions, across the U.S., Europe, and Asia which have followed a whole array of regional crises, and includes the rare synchronised global downturn of 2007/08, following the Global Financial Crisis.”

Despite that encouraging history, an interesting phenomenon is at play this year. While major small-cap benchmarks are trading modestly on the year, they are also trailing the large-cap S&P 500 by wide margins. In turn, valuations on small-cap stocks remain depressed as investors seek perceived safety in larger stocks.

“Recession fears to date have disproportionately hit the valuation of small companies. This can be rationalised because they are more economically sensitive and less liquid than large caps, a characteristic which explains why we have to be macro aware,” added Schroders. “To some extent, the broadly higher quality of large-cap companies allows them more control of their destinies, given their size provides for greater diversification of revenues and operating risk, and greater supply chain power.”

For its part, QQQS is higher by 3.46% year-to-date, an advantage of more than 100 basis points over the widely followed Russell 2000 Index. Another point to ponder: Schroders advocates for considering recessions and recoveries as one phase, not two. That further spotlights opportunities with small-caps because the segment often shines in economic recoveries.

“Additionally, the creative destruction during recession is often more consequential for small companies under more pressing need to right-size their cost base. As a result, they enjoy commensurately more efficient earnings generation during the recovery given how lean and efficient they have become,” concluded the research firm.

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The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.