Small-cap stocks haven’t soared post rate cuts… the headwinds keeping gains in check… is this an opportunity or a warning?… Louis’s focus on small-cap tech
The interest-rate cutting cycle has begun… so why aren’t small-cap stocks soaring?
Let’s back up…
Here’s legendary investor Louis Navellier explaining why we expect small caps to outperform in the wake of September’s 50-basis-point interest rate cut:
Small-cap companies can be some of the most innovative and profitable on the market. But the fact is that smaller companies have bigger debt loads than their large-cap peers and rely on external financing to fund their operations.
With a rate cut, they can reduce their borrowing costs and put more capital towards their operations.
So, while smaller-cap stocks have traded erratically and underperformed large-cap stocks this year, a big rebound may be in the offing.
There’s abundant historical market data to support Louis’s point.
Below, we look at small-, mid-, and large-cap stock performance in the first 3, 6, and 12 months following the first rate cut in a cycle (data beginning in 1954).
Small caps are on the left. You’ll see that they outperform across all three time-horizons. And note the one-year return of nearly 27%.
Source: Calamos Investments
And here’s The Wall Street Journal from earlier this month coming to the same conclusion:
Small caps are expected to rally when rates fall—they typically outpace large-cap stocks in the six months after the first rate cut in a cycle, according to Bank of America Global Research.
But here we are, roughly one month beyond the September rate cut, and large-cap stocks (the S&P 500) are outperforming their small-cap peers by more than 2-to-1. Worse, before last week, small caps had actually lost investors money since September 18.
Why? And does this mean we need to re-think our small-cap positioning this time around?
Well, first, it’s silly to demand immediate, one-month outperformance from small caps just because the Fed cut rates. There are many factors beyond interest rates that influence small-cap performance. And near the top of that list, we have investors’ appetite for risk…
The “treacherous” conditions weighing on small caps
While small caps tend to benefit from lower interest rates, if investors are feeling risk averse, they’re going to avoid small caps in favor of large caps because big companies have stronger balance sheets, diversified revenue streams, and global presence.
As to “risk aversion,” last Friday, JPMorgan Chase CEO Jamie Dimon articulated how many investors feel today:
We have been closely monitoring the geopolitical situation for some time, and recent events show that conditions are treacherous and getting worse…
The outcome of these situations could have far-reaching effects on both short-term economic outcomes and more importantly on the course of history.
While inflation is slowing and the U.S. economy remains resilient, several critical issues remain, including large fiscal deficits, infrastructure needs, restructuring of trade and remilitarization of the world.
While we hope for the best, these events and the prevailing uncertainty demonstrate why we must be prepared for any environment.
Meanwhile, also last Friday, the University of Michigan’s consumer sentiment survey reading came in at 68.9. That’s down from 70.1 in the prior month, and lower than the 71 economists had expected.
Of course, “consumer” sentiment is different than “investor” sentiment. So, where is investor sentiment?
As you can see below, CNN’s Fear & Greed Index puts it at “Extreme Greed” as I write Monday morning.
How do we balance the conflicting influences of “risk aversion” and “Extreme Greed”?
We’re already discussing it: Investors are flooding into stocks but preferring mega caps that are deemed “safer” than small caps.
But the headwinds for small caps don’t stop there…
Are your small caps truly profitable?
Take a guess…
How many small-cap companies don’t make a dime of profits?
Ready?
42%.
That’s 7X the rate of unprofitable companies in the S&P 500.
Here’s the WSJ:
About 42% of the companies in the Russell 2000 are unprofitable, compared with 6% in the S&P 500, according to data from Torsten Slok, chief economist at Apollo.
“It’s profits that matter, and the profits are not being generated by the Russell 2000 companies,” said Michael Rosen, managing partner and chief investment officer at Angeles Investments. “They’re being generated by these big megacap companies, and that’s why they’re the market leaders.”
Moreover, while the Fed has cut rates, it can take a while before lower rates are reflected in a small company’s income statement. Plus, as we’ve been tracking in the Digest, the case for loads of additional rate cuts in 2024 is fading.
In the last two weeks, we’ve gotten a payroll report that blew away expectations, plus a CPI report that showed inflation was hotter than expected. These are not conditions that demand loads of immediate rate cuts.
Right on cue, traders have been recalibrating their expectations. One month ago, the odds of at least 75 basis points of additional rate cuts by December were 58.1%. As I write on Monday, traders have adjusted their bets to 0%.
But are investors focusing too much on these immediate headwinds for small caps? Are we missing some fantastic buying opportunities?
Absolutely, Louis says.
The danger in waiting until small caps feel “safe”
Let’s jump to the great Warren Buffett:
Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well.
And here’s Rob Arnott, founder and chairman of the board of Research Affiliates:
In investing, what is comfortable is rarely profitable.
The time to put money into s small cap isn’t after, say, four quarters of fantastic earnings that prove the company is firing on all cylinders… after investors have already flooded into the stock, pushing it 50% higher… after analysts have upgraded it five times over… and after the stock’s valuation has entered the upper stratosphere.
It’s before that.
It’s when a stock is showing enough signs of fundamental/operational strength to suggest more outperformance is on the way, but before everyone has piled in, pushing valuations to the extreme. And today, a handful of top-tier small-caps stocks are providing exactly that. This is why Louis is urging investors to look at small caps – specifically, small caps that are on the cusp of a historic surge in earnings thanks to AI.
The next wave of AI winners
Let’s jump to Louis’s analysis from Breakthrough Stocks, where he applies his quantitative algorithms to small-cap stocks:
The winners of the Real AI Boom will use generative AI to create profitable companies and reshape existing occupations. This will launch the kind of transformational change we only see once every 25 years. And these changes will roll out across society and reshape America on the same historic scale we saw in the late ’90s.
Many of the everyday jobs that define America will slowly vanish, creating the biggest income gap in our nation’s history as all the money and high-paying work flow to a much different part of our society instead.
And it will flow on a massive scale, in a market that’s expected to grow 20-fold to a whopping $15.7 trillion by 2023. That’s almost the size of China’s entire national output.
I’m talking about next-gen AI companies.
Simply put, these are the companies that use AI to reinvent or automate some of our oldest business models.
Regular Digest readers know that we’ve been spilling lots of ink in recent weeks on AI and automation. Last week, we compared global money flows into AI technology to a tilted billiards table wherein all the pool balls flow to the same corner pocket.
It’s critical that we’re invested in this corner pocket. After all, as we noted a week ago:
In the era we’re entering, there will be just two types of people: the owners of AI, benefiting from the lopsided flow of capital, and everyone else, who are watching AI swallow their former economic productivity like light into a black hole.
Louis holds a similar mindset, which is why he’s directing his algorithms to find the small-cap AI companies that are going to attract the greatest volumes of global capital.
Of course, the benefit of investing in a small-cap AI stock instead of a mega-cap AI stock is that the same sized “swell” of capital can drive a small stock’s price vastly higher than that of the large cap.
Louis has put together research on what he’s finding in the small-cap AI universe today which you can check out right here.
Coming full circle, what are we to make of the lack of “blastoff” from small-cap stocks?
From a macro perspective, it’s understandable. Buying mega-caps is the solution to the conflicting influences of “caution” and “extreme greed.” The state of the world and the earnings environment aren’t yet great for the average small company.
However, this creates favorable buying conditions for investors who can zero in on tomorrow’s small-cap AI winners. After all, we’d rather buy “low” than “high,” right?
So, let the storm clouds keep other investors away – for now. In the meantime, find your AI small-cap leaders, take your positions, and wait for everyone else to wake up to the opportunity and stampede in.
By then, you’ll be the one selling to “me too” investors who waited until everything lined up perfectly… 75%+ gains from now.
Have a good evening,
Jeff Remsburg
