There are two clear divergences taking place in the stock market right. The first is that the Pacer US Small Cap Cash Cows ETF (BATS:CALF), which contains the top 100 free cash flow small-cap stocks, made new highs weeks ago. Meanwhile, the broader Russell 2000 is still stuck below its 2021 peak.
In some ways, this makes sense. Companies with high free cash flow are inherently in a better position to weather the storm of high interest rates.
But the Russell 2000 index is also lagging because it is full of what many refer to as “zombie companies.” These companies, characterized by low margins and high leverage, are at risk of bankruptcy amid climbing rates. They don’t have the free cash flow to deal with higher interest expense as they roll over their debt, putting them at risk of potential default.
Yes — small-cap stocks reflect worries of a credit event. There is no other explanation. Estimates suggest that approximately 24% of small-cap stocks could falter under the strain of higher rates, potentially triggering a surge in unemployment and unsettling the financial stability of numerous sectors.
Credit Spreads Remain Disconnected From Small-Cap Stocks
The second major divergence is that the small-cap narrative is massively disconnected from credit spreads. In turn, credit spreads share close links to the CBOE Volatility Index (VIX).
Traditionally, widening credit spreads signal growing concern over default risks among heavily leveraged issuers. Currently, however, with credit spreads near cycle lows, there is a very clear disconnect. Corporate credit is clearly not reflecting the underlying anxieties gripping small-cap stocks.
And herein lies the core of my concern. All you need is a spark to light the credit-spread-widening fire. All you need is something to widen credit spreads and force them resync to the message of small-cap stocks. Potential triggers range from geopolitical tensions to economic shifts, with Japan’s situation a likely spark.
Despite the uncertainty, one thing remains clear: The market is on the cusp of a significant adjustment. Be prepared.
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.
