Historically, small-cap stocks tend to decline before and after the first interest rate cut, according to Barclays. This contradicts the prevalent notion that small-caps will flourish during the easing cycle, the bank stated. Wall Street remains divided on whether the sector’s upward trend can persist.
Despite the recent surge in interest for small-caps, Barclays suggests that there is little evidence supporting their anticipated boom. Strategists led by Venu Krishna discovered that the Russell 2000, a benchmark index for small-caps, typically experienced a decline once rate cuts commenced.
“We believe this counters the widespread view that the initiation of a rate cutting cycle signals a sustained upward trend for small caps compared to large caps,” their report stated.
The authors compared the Russell’s performance to the S&P 500 across 13 easing cycles between 1980 and 2020. While acknowledging a range of outcomes, a general downward trend was apparent in the 150 days preceding and following the first rate cut.
This finding contradicts numerous prevailing opinions on Wall Street, where heightened bets on lower interest rates have prompted investors to pour funds into the small-cap market. Last Thursday, the Russell surged by 3.6%, even as the tech-heavy NASDAQ fell by 2%.
Many anticipate these stocks to benefit from lower borrowing costs, given their substantial debt exposure. The shift towards small-caps was initially sparked by June’s surprisingly moderate inflation report, which strengthened confidence that the Federal Reserve would cut rates as early as September.
Fundstat’s Tom Lee predicted this week that the Russell could see a 40% upswing by August, citing the oversold nature of its assets.
However, Barclays presented historical reasons why this might not materialize. While declining interest rates could potentially alleviate debt burdens, they can also indicate a weakening economy – a scenario that typically favors large-cap exposure.
“Small caps also continue to face numerous other headwinds, including forward EPS revisions that lag those of their large-cap peers, higher volatility (which is out of favor when the yield curve is exiting inversion and in election years), and heightened vulnerability to trade tensions despite a more domestic sales focus,” Barclays wrote.
Skeptics echo this sentiment. Market veteran Ed Yardeni wrote this week that the small-caps trade lacks momentum, given the sector’s unimpressive forward earnings, revenue, and profit margins.
Meanwhile, others acknowledged the rally but cast doubt on its longevity.
“As the Fed embarks on a rate cutting cycle, markets tend to celebrate it initially and even for a brief period after the cuts begin. But if that cutting cycle coincides with slowing economic data, disappointing earnings, or a rapid compression in multiples, small-caps would likely lose steam quickly,” SoFi’s head of investment strategy Liz Young Thomas stated in written commentary.
She added: “Not to mention, the Fed typically cuts rates late in the economic cycle, not early in the cycle when small-caps tend to have their moment in the spotlight.”
Overall, the outlook for small-caps remains uncertain, with conflicting perspectives on whether the recent rally can endure. While some investors are optimistic about the sector’s prospects, historical data suggests that small-caps may face challenges in the current economic climate. As the debate persists, market participants will closely monitor any developments that could influence the performance of small-cap stocks in the coming months.
Source: https://finance.yahoo.com/news/dont-bet-stock-market-rotation-002153639.html