Sweating the small stuff | USAEMALL.com

Kevin Gordon is a director and senior investment strategist at Charles Schwab & Co.

It’s a small-caps summer. Ignited by that stunning June inflation report, the Russell 2000 initially soared on rate-cut expectations and convinced Wall Street that a “Great Rotation” was under way. Then, US manufacturing and payroll data stoked recession fears emanating from earnings season and returned the small-cap index almost to where it started.

What do these whipsaw moves tell us about investor sentiment and positioning? Will the real driver of the small-cap rally please stand up?

Rate cuts good or bad? Yes

Given small-cap companies are saddled with more floating-rate debt and have a larger chunk relative to large caps coming due in the next several years (more on that in a bit), it’s logical to think that the Fed’s aggressive rate-hiking cycle was a key driver of their underperformance since 2021. As such, it’s logical to think the opposite is true.

Indeed, it is the case that on average, the Russell 2000 tends to do well the year after the Fed starts cutting rates — an average gain of 11.4 per cent, as shown in the chart below.

However, be careful applying the word “average” when it comes to Fed cutting cycles. Hiding behind that average is a maximum gain of 53.3 per cent and a minimum of -16.1 per cent.

Keep max and min in mind

If we dissect performance further and look at when rate cuts have occurred in the context of a recession, the average gain is weaker at 8.9 per cent, but with the same maximum gain of 53.3 per cent and minimum of -16.1 per cent.

Recessions weigh on performance

Unsurprisingly, the picture is a bit rosier when there isn’t a recession that follows the first rate cut, given the average gain in the following year is 14.5 per cent. The range of returns is also much tighter, with a maximum gain of 22.2 per cent and a minimum of -2.9 per cent.

Stocks prefer no recession

Perhaps the excitement around small caps is exacerbated in this cycle by the larger share of debt coming due for companies in the Russell 2000 relative to the S&P 500, as shown in this next chart. If (for argument’s sake) the Fed starts cutting in September and proceeds to cut by 25 basis points at every meeting through the end of 2025, it would take the fed funds rate to half of where it is today. Suddenly, these huge shares of debt coming due in 2026-2029 look a bit less scary — still an issue, for sure, but not Armageddon.

‘Til debt do us part

Then, there’s the zombie argument. Nearly a third of the Russell 2000 is made up of so-called zombie companies — those that don’t earn enough to pay off their interest expense. The growing share has been a trend for nearly 30 years. Fortunately, the current share of zombies has come down over the past couple of years and is not far from where it was in 2018-2019.

Undoubtedly, these companies would like to see lower rates, but the reality is that today’s Fed does not want to go back to the ZIRP era, so outperformance from lower-quality small caps that tend to do well after aggressive cutting cycles isn’t likely (and is in fact already fading).

They’re . . . alive?

Is it just vibes and maths?

It’s safe to say there are some valid, fundamental reasons as to why small caps have had such an aggressive turn in anticipation of a rate cut. It also seems, however, that one of the more dominant forces has been related to sentiment — or, as this cycle has preferred, vibes.

One of the most unique aspects of this bull market is how feeble and lean it was in its youth. This next chart looks at the Russell 2000’s performance after full bear market cycles for the S&P 500 — the definitive trough after a decline of at least 20 per cent — going back to the inception of the Russell 2000.

In the first year of the bull market that started in October 2022, the index was nearly flat. In fact, if you were to bring the x-axis out just a bit further, it would show that the Russell 2000 fell below its prior bear market low, which is not normal (and has never happened before). Investors got quite aggressive with their selling of small caps as they chased large caps for perceived safety.

Is it believa-bull?

The index math also did not work in small caps’ favour. Large-cap indices like the S&P 500 are dominated by tech, which has been the poster child of the current bull market in terms of performance and size. It happens to have several members worth trillions of dollars; and even if they are not always the best performers, their weight helps disproportionately drive the index’s gain.

Conversely, when value and cyclically oriented sectors start to do well, that tends to benefit small-cap indices to a much larger degree. As shown in the chart below, slightly more than half of the Russell 2000 is made up of the consumer discretionary, industrials, financials, and energy sectors. If tech takes a breather while its cyclical peers run, it’s quite difficult for an index like the S&P 500 to handily outperform the Russell 2000.

It’s all in the numbers

So, which is it?

As is the case with any market move, Wall Street is always in search of what the main driver is — be it actual fundamentals or just vibes. One could argue it’s a mix this time. Perhaps investors got too aggressive in assuming how long the Fed would stay on hold, thus believing that small caps’ indebtedness would challenge their survival in a higher-for-longer environment — and that was reflected in the Russell 2000’s lack of participation in the early stages of this bull market.

Investors then seemed to course-correct on both fronts. Vibes have certainly improved and the rate path looks a bit less scary; so, it makes sense that the proverbial rubber band has snapped back, causing small caps to finally catch up.

From here, a lot still has to go right to avoid a small-cap winter. As we stare down the barrel of a softening labour market and cooling economy, now is when we start to see whether investors are willing to put their money where their vibes are.