For nearly a year I’ve been highlighting the divergence in performance between small-cap and large-cap stocks. Most stocks, which are small-caps, are still trading below their respective 2021 highs. While it’s clearly a large-cap bull market, it’s been extremely narrow with many stocks floundering beneath the surface. The reason? Higher-for-longer interest rates have been a big headwind for many small-cap companies that are already very leveraged. Rolling over that debt into higher rates when many of these small-caps have razor thin margins is risky. It’s difficult to imagine a scenario where some of them don’t go bust.
Now keep in mind – small-caps relative to large-caps peaked in 2011. It’s clear, as you can see on the graph below, that it’s been a terrible 10+ years. Because relative momentum peaked in 2011, any relative strength that appeared to be beginning in small-caps has failed.
Key to small-cap outperformance will be large-cap weakness, particularly in specific sectors. Tech dominates large-cap indices, while small-caps have more exposure to industrials, consumer discretionary and health care/biotech plays. So, from a big picture perspective, any call on small-caps is inherently a call on large-cap tech no longer being the leader of market momentum. This is a distinct possibility — it’s just a question of when.
Is the higher-for-longer narrative over?
I’m conflicted here. I would absolutely love to see a small-caps run, no different from what happened from the oversold lows post-Covid. There was a vertical period of incredible strength coming out of the reopening and 2020 election. Maybe we are about to see a repeat of that. If the Fed is indeed done with hiking rates and we see cuts, concerns about zombie companies rolling over their debt into higher rates largely goes away. This, of course, would be a positive.
Some of these stocks are trading at distressed valuation levels because of the higher-for-longer narrative. If that narrative is over, there could be aggressive movement back into these junk companies simply because they have a higher likelihood of surviving.
By the same token, I’m still concerned about the reverse carry trade from a short-term dynamic perspective, and about investors who are positioning themselves overwhelmingly bullish with no hedging whatsoever. Once again, everyone is on the same side of the boat holding an anvil. Don’t get me wrong — it’s clearly working. However, I get nervous of a sustained rotation into small-caps. It seems everyone is already bulled up and ignoring other macro risks simply because charts are going up and to the right for now.
For long-term investors, it’s not a bad idea to consider positioning away from large-caps and into small-caps, just in case last Thursday was the turn. As the trend persists (if it does) then investors should lean more into it. But right now it is early. Anyone taking a big allocation in small-caps should know it could be a false move.
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.
On the date of publication, the responsible editor did not have (either directly or indirectly) any positions in the securities mentioned in this article.
