While everyone has been screaming about the “new bull market,” the reality is that most stocks are basically flat for the year. They have performed relatively poorly despite pre-election year dynamics usually favoring equities. When we look at the ratio of the Russell 2000 to the S&P 500, we can clearly see that small-cap stocks relative to large-cap stocks are actually lower than their lowest point of the Covid-19 crash of 2020.
Small-cap stocks refer to the shares of publicly traded companies with a market capitalization between $300 million and $2 billion. These stocks are typically more volatile and riskier than large-cap stocks, but they offer higher potential returns. Investors often see small-cap stocks as an opportunity to invest in emerging companies before they become big players in their respective industries.
They also tend to be more levered. This is where the zombie company dynamic kicks in — and it’s why everyone should be paying attention.
Stock Market Crash Alert: Watch Small-Cap Stocks
A “zombie company” is a firm that is unable to generate enough cash flow to cover its interest expenses. They rely on external financing to continue operating. These companies are often characterized by high levels of debt and are particularly vulnerable to changes in economic conditions and interest rates. The proliferation of zombie companies can be attributed to the prolonged period of low interest rates, which has allowed them to roll over their debt and keep their operations running.
And because most crises historically are inherently refinancing crises, this should concern every single person out there.
These companies are essentially “dead” in terms of their financial health, yet they continue to exist due to the availability of cheap credit. The concern is that these companies won’t survive if interest rates stay elevated for a prolonged period, leading to mass bankruptcies and a potential further crash in the small-cap market.
The Bottom Line on Zombie Companies
This is already happening in the private economy. So, what happens next? I believe that the disconnect between bankruptcies and credit spreads gets resolved by a slew of zombie companies going under, potentially next year.
If that thesis is correct, the stock and bond market wouldn’t respond next year. They would respond in advance this year.
This was always my original thesis: We are in a melt-up year but a credit event likely would occur toward the end of 2023 because of the lagged effects of the fastest rate hike cycle in history. The weakness in small-cap stocks so far in September is the second worst for a pre-election year, after 1987 (and the crash that followed). Investors, beware.
On the date of publication, Michael Gayed did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.