Don't bet on the stock-market rotation as small-caps historically suffer when rates come down, Barclays says / Why the stock market's rotation into small-caps will be short-lived

Dear all,

I am posting these two recent articles as reference. It is on-topic with previous forum discussion and should belong to the forum.

It may not be a popular topic as most P123 members with US micro/small cap models probably don't want what is described to happen next.

Pls take a look if you have time.

Regards
James

Don't bet on the stock-market rotation as small-caps historically suffer when rates come down, Barclays says

Filip De Mott

Jul 20, 2024, 12:21 AM GMT+8

  • Small-caps historically decline before and after the first interest rate cut, Barclays reported.
  • This argues against the growing narrative that the easing cycle will boost small-caps, the bank said.
  • Wall Street is divided on whether the sector's rally can continue.

Small-caps are getting new love on Wall Street, but not much supports the expectation for the sector to surge, Barclays wrote.

In fact, strategists led by Venu Krishna found that the small-cap-tracking Russell 2000 typically declined once rate cuts started.

"We think this argues against the popular narrative that the start of a rate cutting cycle signals a sustainable uptrend for small caps vs. large caps," the note said.

The authors compared the Russell's performance to the S&P 500 through 13 easing cycles from 1980 to 2020. Although the note acknowledged a range of outcomes, a broad downtrend was evident in the 150 days before and after the first cut.

Barclays Research

Their finding opposes many prevailing viewpoints on Wall Street, where rising bets of lower interest rates have sent investors piling into the small-cap trade. Last Thursday, the Russell rose 3.6%, even as the tech-heavy NASDAQ shed 2%.

Many expect these stocks to benefit from lower borrowing costs, given their high debt exposure. The rotation into small-caps was first sparked by June's surprisingly cool inflation report, which bolstered confidence that the Federal Reserve would slash rates as soon as September.

The Russell faces 40% upside by August, given how oversold its assets have been, Fundstat's Tom Lee predicted this week.

But Barclays outlined why this might not be the case historically. In part, falling interest rates might help ease debt burdens, but they can also signal a cooling economy — which 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 agree. Market veteran Ed Yardeni wrote this week that the small-caps trade has no legs, given the sector's lackluster forward earnings, revenue, and profit margins.

Meanwhile, others acknowledged the rally but questioned its staying power.

"As the Fed embarks on a rate cutting cycle, markets tend to cheer it initially and even for a short period after the cuts begin. But if that cutting cycle occurs in concert with slowing economic data, disappointing earnings, or a quick compression in multiples, small-caps would likely lose steam quickly," SoFi's head of investment strategy Liz Young Thomas said 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."

Why the stock market's rotation into small-caps will be short-lived

Matthew Fox

Jul 18, 2024, 3:33 AM GMT+8

  • The recent surge in small-cap stocks appears unsustainable, according to Capital Economics' John Higgins.
  • Higgins said the fact that large-cap stocks are still near record highs suggests no rotation has taken place.
  • "We are not convinced" of a rotation from large-cap stocks to small-cap stocks, Higgins said.

The rapid and historic rally in small-cap stocks over the past week is unsustainable.

That's according to Capital Economics' chief market economist John Higgins, who said in a note on Wednesday that the relative outperformance of small-cap stocks compared to large-cap stocks is likely to be short-lived.

"A recent surge in the Russell 2000 after the US CPI report for June was published last week has prompted claims that we are entering the initial stage of a secular rotation into US small-cap stocks. We are not convinced," Higgins said.

First, Higgins said the recent market action shouldn't be thought of as a rotation.

A rotation implies that investors are selling large-cap stocks and using those proceeds to buy small-caps. But while large-caps have sat out the rally over the past week, they are still just a few percentage points below all-time highs.

"We would need to see more evidence of a sell-off in 'big tech' to be convinced that a rotation into small-cap stocks out of their larger counterparts was well and truly underway," Higgins said.

Higgins made those comments while acknowledging the sharp decline in mega-cap tech stocks on Wednesday, sparked by comments from former President Donald Trump and the Biden administration considering restrictions on certain semiconductor companies.

Much of the rally in small-cap stocks has been driven by the expectation that the Federal Reserve will soon lower interest rates.

But Higgins isn't buying that argument either, noting that large-cap stocks outperformed their small-cap peers when the Fed cut interest rates in the mid-1990s, as well as when they cut interest rates in 2009 and 2019.

"We anticipate a bubble in the stock market continuing to inflate amid hype around AI, like one did in the second half of the 1990s around the internet. Back then, small-cap stocks generally underperformed their large-cap peers until mid-1999," Higgins said.

Finally, Higgins highlighted that the biggest factor driving stock market performance is earnings, and there's no sign yet that small-cap stocks are going to overtake large-cap stocks in terms of earnings growth.

"It remains to be seen whether big tech firms will fail in general to continue to beat analysts' lofty expectations for their earnings," Higgins said.

The first round of second-quarter earnings results for the mega-cap tech companies are set to drop next week with reports from Tesla and Alphabet.

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