I’ve long warned that small-cap stocks are at risk – and that many companies will not be able to survive higher-for-longer interest rates.
However, investors have already priced in a lot of bad news to these small-cap stocks… and a turnaround may be underway. The Russell 2000 index is starting to outperform the Pacer US Small Cap Cash Cows 100 ETF (BATS:CALF). The CALF exchange-traded fund is made up of small-cap stocks with the highest free cash flow. So, the fact that the Russell 2000 is outperforming it is a good thing, because the first stage of a turnaround should come with speculative buying in the most distressed parts of the market.
Note that this is happening despite the ratio of small-cap stocks to large-cap stocks hitting new lows last week. So, on the one hand, it’s clear investors still have concerns about these smaller companies, which is why money is still flowing into the mega-cap momentum.
On the other hand, it looks like some speculative rotation is happening within the small-cap stock universe.
What to Expect With Small-Cap Stocks
I can’t ignore the possible bull case, at least in the short term, that small-cap stocks are due to rebound and close some of the gap against large-caps. One catalyst for this is that, with unemployment now at 4%, investors may be betting that the Federal Reserve will react and begin cutting interest rates soon. Lower interest rates would benefit these smaller companies, potentially explaining their recent positive performance.
I don’t suspect any rebound in small-cap stocks will last long. I say this purely because the math behind unprofitable companies in a high-interest-rate world doesn’t suddenly change because of a short-term trade. But I do think that there might be a surprise rally. Plus, if the market were to enter a downtrend, I believe that small-caps could outperform large-caps on a relative basis, just like they did from 2000-2002.
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.
