The Problem With The Russell 2000

It made an already precarious situation worse.

That’s one way to describe the knock-on effect of last month’s short squeeze for the quality of US small-caps.

While the furious rally in GameStop and other Reddit “meme stocks” grabbed all the headlines, SocGen’s Andrew Lapthorne this week noted that “the broader rally in stocks with bad balance sheets has been going on for longer than this short-squeeze.”

In fact, the weighting of lower-quality companies in the index is the highest going back at least to the financial crisis, according to Lapthorne. The figure (below), shows that the situation was rapidly worsening prior to last month, when the GameStop circus came to town.

This is potentially perilous for reasons that are not only obvious but self-evident. The percentage of the index comprised of companies with the worst balance sheets has doubled (and then some) in a very short period of time.

The good news is that if the recovery gathers steam, earnings will improve, which should make leverage ratios look less daunting. Capital markets were wide open for corporate borrowers last year, with both investment grade and junk companies issuing record amounts of debt. In the early days of the pandemic, credit lines were drawn down, and over the course of 2020, soaring stock prices also tempted the C-suite to tap the equity market. That left companies sitting on lots of cash, but Lapthorne implored market participants not to forget that “this cash was raised for good reason, to keep companies afloat.”

One read-through from the above is simply that small-caps, as a group, are becoming increasingly disconnected from their collective balance sheet risk due to the surge in the prices for the worst of the bunch.

“And herein lies the broader risk for the Russell 2000,” Lapthorne wrote. “The rally in lower quality names, stocks which by nature are in financial difficulty, now have share prices that do not accurately reflect these risks, and this is pushing up the sensitivity of the Russell 2000 to future credit risk.”

Is this ameliorated by low rates and the distinct possibility that earnings will improve in a better economic environment?

Well, kinda. But not entirely. “Net debt-to-EBITDA is still at unprecedented levels and despite record low levels of interest rates, current aggregate reported EBIT cannot meet interest payments,” SocGen warned.

Even if you assume pre-pandemic levels, interest payments would chew up 60% of EBIT, according to the bank.