Small-cap stocks are flashing signs of a 'nasty recession' on the horizon and investors should stick with cyclical names to thrive in the bear market, Jefferies says

• Small-cap stocks are pricing in a steep recession, Jefferies said in a note to clients Tuesday.
• The Russell 2000 has dropped 28% from its all-time high and has declined 20% so far in 2022.

Small-cap shares are entrenched in a bear market and look set to fall even further as investors see signs of a contraction coming for the world's largest economy, according to Jefferies.

The Russell 2000 index has lost 20% on a year-to-date basis and it has stumbled 28% since hitting an all-time high of 2,458.86 in November.

"Small is pricing in nasty recession and decline worse than many bear markets: It just keeps getting worse for small caps with performance from the peak worse than the average recession and even worse than the average pullback," equity strategists led by Steven DeSanctis wrote in a research note. Jefferies has previously pointed out that in the first half of a recession, the average decline for small-caps has been 14%.

"We are done trying to call the bottom of small caps," the bank said, as outflows from both active funds and ETFs persist.

Small and large-cap stocks have been slammed lower this year as investors anticipate the US economy will tip into a recession as the Federal Reserve quickly increases interest rates to cool down inflation. Inflation hovering at a four-decade high above 8%.

The large-cap S&P 500 index briefly tipped into a bear market last week and looked set to fall during Tuesday's session.

The Russell 2000 has lagged behind large-cap shares by 23% since mid-March 2021, "and to say the size segment is due for a bounce is an understatement," said Jefferies.

Meanwhile, the investment bank reiterated its overweight recommendation for cyclical stocks.

"It has been a rough few weeks for the Cyclical sectors, but the group is holding up better than Secular Growth and the overall index," said DeSanctis, adding that sentiment has grown "really ugly" for this segment with large ETF outflows from Financials, Discretionary, and Materials.

"But when the bear market ends, this group lags marginally versus Secular Growth right out of the box," he said, and it "plays a game of catch up over the following three months to where there is little difference between these two cohorts."

Earnings and sales revision ratios are holding up well for cyclicals compared with the secular growth and bond proxies groups. Estimated earnings growth for cyclicals in 2022 is at 18%, while secular growth has dropped to 1.7%, it said.