I’ve talked about “zombie company” dynamics when it comes to small-cap stocks and I believe that we are now at a critical juncture. The Russell 2000 Index has been in a violent, sideways pattern all year. As of this writing, it is hitting resistance again for the fourth time in 2023.
I keep saying small-cap stocks hold the key because if lower rates are perceived as positive for the economy and not a sign that something is breaking, then small-caps should disproportionately benefit.
After all, these are highly levered companies that are very dependent on growth and the cost of capital. Lower rates should give a lifeline to these stocks which otherwise would not survive.
Let’s play out two short-term scenarios. If small-caps break out given this massive drop in bond yields, then a “great rotation” into year-end out of large-cap stocks and into small-cap stocks means a catch-up trade is underway.
So that’s scenario 1. Yes, this is possible, but I think scenario 2 in the near term is more likely. That scenario says that the drop in bond yields is NOT bullish. That Federal Reserve Chair Jerome Powell knows something we don’t that spooked a change in the Fed’s policy outlook. And if that’s the case, it means the Fed may be worried about a corporate credit event after all.
Under that scenario, small-cap stocks turn back down, just as everyone get sucked into the stock market.
Why do I think scenario 2 is more likely? There are no bears left. I have NEVER seen overconfidence by bulls as high as it is today. Look at what sectors are leading right now. If it’s a bullish move, why are utility stocks outperforming tech stocks?
The Bottom Line
Something else is happening here, and I keep stressing the fact that the year is not over for a reason. Investors could be totally misinterpreting the WHY of long-duration yields collapsing. The macroeconomic backdrop still looks troublesome, and tail risks remain elevated particularly on the global front in China and Japan.
Bear markets make fools of bulls and bears. This is a fascinating setup now.
Stocks can still get pancaked.
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.
