Yahoo Finance Small caps are the latest 'pain trade' putting the hurt on Wall Street: Morning Brief
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Small cap stocks are finally perking up — just in time to catch Wall Street flat-footed yet again.
Since Friday's job report, the Russell 2000 (^RUT) has surged 7%, rising in excess of 2% in three of the last four trading days. Meanwhile, the year's best-performing index, the Nasdaq 100 (^NDX), is fractionally lower over this period after surging more than 30% in 2023.
Another example of what Yahoo Finance’s Ines Ferré noted Wednesday is a market rewarding this year the biggest losers from last year.
For all the concerns about market gains being concentrated among a select few companies, the megacap rally appears to be broadening, or at least shifting into other areas.
The question for investors is: does this latest rotation have legs? Or, conversely, will the small cap rally peter out and reverse just as quickly, causing more frustration for investors?
Generally defined to be under $2 billion in market capitalization, small cap stocks are highly sensitive to the domestic economy and tend to do better when the economy is improving.
They are also highly levered to the financial sector, as this cohort is home to many regional banks. Not surprisingly, the internet bank crisis that unfolded in March hit the Russell 2000 disproportionately hard.
In that regard, small caps are highly sensitive to interest rates, as interest payments can consume a big chunk of sales. Companies that routinely tap the capital markets by selling their stock or issuing debt to fund operations have been feeling the pinch of the Fed's aggressive rate hikes since last year.
However, the fallout in terms of the price of money has been contained.
Looking at the high yield debt market that services companies with lower credit ratings, spreads above the risk-free Treasury yield in March barely exceeded 5% — far short of the levels seen in prior episodes of market stress.
Accordingly, with the "panic" apparently contained, investors seem to be interpreting Friday's strong payrolls gain as a sign that US growth may not take a big hit this cycle.
And this outcome would favor a "catch-up" rebound in small cap returns until the next major catalyst arrives.
Several technical reasons are also supporting the short-term, tactical bullishness in small caps.
Index traders in the futures market are short the Russell 2000, adding fuel to any squeeze higher. Also, performance relative to the megacap Nasdaq 100 had become extreme just prior to Friday's bounce, which means mean reversion is also at play.
Longer-term, investors should be aware that a bet on small caps is not only a bet against a hard landing, but also against a recession, in general.
If the markets are setting up like 1998 or 2019 — when stocks rebounded relatively quickly from a mere slowdown in earnings — stocks ought to post sizable gains this year.
Conversely, if this is more like the recessionary periods of 2001 or 2008, small caps could be in for a drawdown measured not in months, but years.
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