Sweat the small stuff

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

It’s a summer with small capital letters. Buoyed by that stunning June inflation report, the Russell 2000 initially rallied on expectations of a rate cut and convinced Wall Street that a “big turnaround” was underway. Then, data on U.S. manufacturing and wages fueled recession fears emanating from the earnings season and brought the small-cap index back close to where it started.

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

Good or bad rate cuts? Yes

Given that small-caps are loaded with more floating-rate debt and have a larger share of high-caps coming due in the next few years (more on that in a bit), it makes sense to believe that the Fed’s aggressive rate hike cycle was a key driver of their underperformance in 2021. As such, it makes sense to believe that the opposite is true.

Indeed, it’s 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%, as shown in the chart below.

However, be careful about applying the word “average” when it comes to the Fed’s cutting cycles. Behind this average hides a maximum gain of 53.3% and a minimum of -16.1%.

Keep in mind the max and min

If we look further into performance and look at when rate cuts occurred in the context of a recession, the average gain is weaker at 8.9%, but with the same high gain of 53.3% and low of -16.1%.

Recessions affect performance

Unsurprisingly, the picture is slightly rosier when there is no recession following the first rate cut, given that the average gain over the next year is 14.5%. The return range is also much narrower, with a maximum gain of 22.2 percent and a minimum of -2.9 percent.

Stocks prefer no recession

Perhaps the excitement surrounding small caps is exacerbated this cycle by the larger share of debt owed by companies in the Russell 2000 compared to the S&P 500, as shown in the following chart. If (for argument’s sake) the Fed starts tapering in September and continues to cut by 25 basis points at each meeting through the end of 2025, the federal funds rate would be cut in half from what it is today. Suddenly, these huge shares of debt due in 2026-2029 seem a little less scary – still a problem, to be sure, but not Armageddon.

Till 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 their interest expenses. The growing share has been a trend for nearly 30 years. Fortunately, the current zombie quota has dropped over the past two years and is not far from where it was in 2018-2019.

No doubt these companies would like to see lower rates, but the reality is that today’s Fed does not want to return to the ZIRP era, so it is not likely to outperform lower-quality small caps, which tend to does well after aggressive downsizing cycles. (and actually fading already).

They are. . . alive?

Is it just vibrations and math?

It’s safe to say there are some valid and fundamental reasons why small caps have taken such an aggressive turn in anticipation of a rate cut. It also seems, however, that one of the most dominant forces was related to feeling – or, as this cycle preferred, vibration.

One of the most unique aspects of this bull market is how thin 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 threshold after a decline of at least 20 percent — dating back to the Russell 2000’s inception.

In the first year of the bull market, which began in October 2022, the index was almost flat. In fact, if you were to pull the x-axis out a little further, it would show that the Russell 2000 has fallen below the previous bear market low, which is not normal (and has never happened before). Investors became quite aggressive in selling small caps as they chased large caps for perceived safety.

Is believa-bull?

The index math didn’t work out in favor of lowercase either. Large-cap indices such as the S&P 500 are dominated by technology, which has been the model of today’s market in terms of performance and size. They happen to have several members worth trillions of dollars; and even if they are not always the best performers, their weight disproportionately helps to increase the index.

Conversely, when value-oriented and cyclical sectors start to do well, this tends to benefit small-cap indices to a much greater extent. As shown in the chart below, just over half of the Russell 2000 is made up of the consumer discretionary, industrials, financials and energy sectors. If technology takes a break while it’s underway, it’s pretty difficult for an index like the S&P 500 to easily outperform the Russell 2000.

It’s all in the numbers

So which one is it?

As with any market move, Wall Street is always looking for what the main driver is – whether it’s real fundamentals or just vibrations. One could argue that this time it’s a mix. Perhaps investors have become overly aggressive in their assumptions about how long the Fed will stay on hold, believing that small-cap debt would jeopardize their survival in a longer environment — and that was reflected in the lack of participation in the Russell 2000 at the beginning of the year. the stages of this bull market.

Investors then appeared to correct course on both fronts. The vibrations have definitely improved and the duck path looks a little less scary; so, it makes sense that the proverbial rubber band snapped back, causing the small caps to finally catch up.

From here, he still has a long way to go to avoid a winter with low sevens. As we stare down the barrel of a weakening job market and a cooling economy, we’re now starting to see if investors are willing to put their money where their vibes are.