Small-cap stocks have reached a potential critical moment. In 2021, the Russell 2000 went sideways, had a false breakout toward the end of the year, then plummeted into the 2022 bear market. In 2023, small-cap stocks went sideways for the bulk of the year. Now, they seem to be following a similar pattern where they had a false breakout and are being rejected again.
The Russell 2000 index, a benchmark for small-cap stocks, has been a barometer of just how deceptive this “new bull market” has been.
Small-Cap Stocks Are Already Struggling in 2024
Despite occasional rallies, the index has struggled to sustain its momentum, faltering when compared to the gains of large-cap indices such as the S&P 500 or the Nasdaq-100.
Investors have a long-standing affair with mega-cap stocks—those with market capitalizations typically in the hundreds of billions or more. These corporate giants offer a sense of security and stability that is often not found in their small-cap counterparts. Companies like Apple (NASDAQ:AAPL), Amazon (NASDAQ:AMZN), and Microsoft (NASDAQ:MSFT) have become safe havens, especially in times of market uncertainty or volatility.
In conditions where investors return to mega-cap favorites, small-cap stocks are overshadowed. This is a pattern we see in various market cycles, where risk aversion pushes capital toward larger, more established companies. The flight to quality becomes pronounced, especially when the economic outlook is murky or when market sentiments are bearish.
The narrative of a “soft landing,” in which the Federal Reserve successfully manages to cool off inflation without triggering a recession, had previously buoyed markets and lifted small-cap stocks in November and December. The “Fed pivot,” a potential shift toward a more accommodating policy stance, provided a glimmer of hope.
However, for small-caps to embark on an extended run, they require more than just a narrative — they need tangible results. The markets are looking for a follow-through on these policy expectations. Without concrete evidence of a soft landing or a pivot from the Federal Reserve, the temporary boost that small-cap stocks experienced may have been transitory.
Why? Because a worrying aspect of the small-cap index is the presence of “zombie companies” — firms that are not financially robust enough to cover their debt interest payments with current profits for an extended period. These companies are particularly vulnerable in an environment of rising interest rates.
The Bottom Line
As the Fed continues to combat inflation, there is a possibility of even higher interest rates. Companies with heavy debt loads will face increased costs when rolling over their debt, squeezing their already thin margins. The survivability of these “zombies” is in serious question, as they may not be viable as going concerns in a tightened credit market.
While small-cap stocks have historically provided opportunities for significant returns, current market dynamics raise concerns about their immediate future. Investors are gravitating toward the perceived safety of mega-cap stocks, and the looming threat of higher interest rates puts additional pressure on small-cap companies, especially those burdened with high levels of debt. The market is waiting for a clear direction from economic indicators and Fed policies. Until then, small-cap stocks may find themselves in a precarious position, struggling to attract investor confidence and capital. And serving as a key warning that we are still in a high-risk cycle that is fooling everyone.
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.
