What does the rebound in manufacturing signal for stocks?
At times, the stock market can appear to be disconnected from the real economy, performing well despite negative economic news or vice versa. Since late March, large-cap growth companies have experienced a strong rebound even as the economy was contracting sharply. Notably, cyclically sensitive small-cap value stocks also were hard hit during the downturn but have since lagged as equities surged. With data now indicating that the economy is also in recovery, should we expect these same trends to persist? Looking to the manufacturing sector may provide insight.
As illustrated in the chart above, when manufacturing activity rebounds from the bottom, small-cap value stocks (measured by the Russell 2000 Value Index) have typically outperformed their large-cap peers over the ensuing three years. Why? First, small companies tend to do less business overseas and are thus more closely tied to the U.S. economy than large multinational firms. Secondly, the small-cap value index has much higher exposure to financials and industrials that are more sensitive to cyclical fluctuations and can benefit disproportionally when the economy accelerates.
The recent surge in COVID-19 cases creates some risk to the near-term outlook for the economic recovery, but a durable rebound in growth should benefit small-cap stocks.
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