So why are small-cap stocks key to understanding the market right now?
The last couple of months have been particularly telling for small-cap stocks, as their fluctuations have been closely tied to the anticipated trajectory of interest rates. The Federal Reserve’s communications before and during the December meeting suggested an end to the rate-hiking cycle, with multiple rate cuts forecast for 2024. This was met with enthusiasm in the markets, leading to a bounce that notably lifted sectors like industrials and materials.
The initial reaction to the Fed was perhaps too optimistic, with the market hastily pricing in as many as six rate cuts. The subsequent release of healthy economic data prompted a reassessment of these expectations.
The Fed has been keen to moderate these expectations, resulting in a more hawkish investor stance. The recalibration is evident in the recent upswing of about 35 basis points in 10-year Treasury yields, and a shift in equity markets, where the cyclical rally has faded. This has allowed mega-cap tech stocks to reclaim their dominance.
Small-cap stocks are inherently more leveraged than their large-cap counterparts, which magnifies their sensitivity to interest rate changes. This leverage can be a double-edged sword, enhancing returns in favorable conditions but exacerbating declines when the tide turns. The Federal Reserve has signaled its intent to maintain higher rates for an extended period. This stance, if upheld, suggests that small-cap stocks may continue to underperform until a more decisive shift in Fed policy occurs.
Why Small-Cap Stocks Matter Right Now
It also puts small-cap stocks at risk as the credit event thesis remains in play.
A looming debt refinancing crisis threatens both small and large companies within the next two years. Companies may struggle if forced to refinance at higher rates, potentially leading to failures among “zombie” companies, thus impacting the broader risk asset market. Conversely, if lower rates are lowered in the nick of time, these companies could recover and spearhead a market upturn.
The Bottom Line
From a fundamental standpoint, justifying multiple rate cuts soon is challenging.
While peak inflation may have passed, allowing for some normalization of policy, the economic indicators do not align with the market’s initial expectation of aggressive rate cuts. This makes the outlook for small-cap stocks a mixed bag. On one hand, without the anticipated rate cuts, these stocks could face further headwinds. On the other hand, the Fed’s cautious approach might be what the economy needs to achieve a “soft landing,” avoiding a more severe downturn.
I remain deeply concerned with ongoing failed momentum in small-cap stocks.
I have been ridiculed for arguing we may still be in a bear market by people who don’t see why. This is often the very reason why the argument may be right, as people are being fooled by ongoing momentum and idiosyncratic risk with large-cap tech masking the real message of the market.
On the date of publication, Michael Gayed did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
