“Rotation” is the buzzword of the day, with every major financial media outlet arguing that what we are seeing is rotation out of large-cap stocks and into small-cap stocks. Recall that mid-October I argued that if a credit event in corporate debt doesn’t happen, the way to play it would be small-cap and emerging market stocks. The small-cap move has been quite aggressive the last few weeks, and this should make sense. Small-cap stocks have been abysmal performers relative to large-caps all year. Their leadership now means stocks must go higher, right?
Not so fast.
I unequivocally believe that this ratio should continue to rise in the months ahead. Small-cap stocks tend to outperform large-caps in election years, and the one-sided nature of market strength in 2023 makes the likelihood of leadership reversal very high.
The problem is that relative strength here doesn’t necessarily have to mean broad equities make money. Consider that we saw small-caps outperform large-caps during the 2000-2002 bear market as tech took the brunt of the pain from the dot-com burst.
I’m not necessarily saying that’s the setup here, but I still believe that the Federal Reserve’s rate hike cycling disproportionately hit small businesses and zombie companies, of which many are in the small-cap averages. The fundamental underpinnings remain challenged until a washout occurs in broader equity sentiment, which just hasn’t happened yet.
There’s more to this though. The argument is that many managers, in an attempt to catch up to the S&P 500, will YOLO into small-cap stocks as their only means of getting some year-end performance.
The Bottom Line
My problem with that is that many managers are more likely to sell small-cap stocks than buy them for tax purposes into year-end. Never mind that fact that most managers also are mandate-driven, meaning they don’t necessarily have to rotate into small-caps because simply, they can’t.
With all that said, yes, I’m confident that small-cap stocks can relatively outperform large-caps given how bombed out they are, but by the same token, that doesn’t mean they have to make money. The relative behavior could simply mean they go down less than large-cap stocks in another wave lower for the stock market. That still works for asset allocators mind you.
The perspective here should be that rotation is likely happening, and relative strength can persist, but absolute performance within that is by no means guaranteed.
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.