A Global Rally? The Case for Small Cap Outperformance
Sentiment in the US markets has become shaky, derailing a rally driven amid the prospect of looming interest rate cuts. Artificial intelligence (AI) stocks have continued to drive broad performance gains at the expense of small caps. Higher treasury yields too, such as Treasury bills and money market funds are making equities look less attractive adding to small cap investment displacement. On the positive side, US indexes are on track to finish the trading month higher culminating with Friday’s closing bell.
As we wrote two weeks ago, the elevated interest rate environment has seemingly held back micro and small caps who since are more sensitive to interest rate fluctuations. The disparity between large and small caps suggests that when the Federal Reserve does begin cutting rates, small caps could potentially recover and shine again. In the meantime, contrarian investors are taking advantage of unloved equities on the cheap with great growth prospects.
There is recent historical evidence to support this optimism. For instance, the Russell Microcap index rose by 5.4% on November 14 on the prospect of rate loosening.
Similarly, when the Federal Reserve indicated the possibility of three rate cuts in 2024, the Russell Microcap index gained 3.8% on December 13th and 2.3% on December 14th. This type of market reaction reflects a larger discussion about the forces driving stock market performance: macroeconomic factors vs. interest rates.
Even though small caps are currently at one of the lowest points of profitability historically, there is room for hope. Because the disparity seems to be more about the composition of the market rather than any inherent profitability issue. The small cap space today boasts more innovation than it did two decades ago, suggesting that while profitability may be lower, the potential for growth and innovation is high.
In the UK market, there is no dearth of undervalued stocks with limited downside. The FTSE and the Dow may have reached record highs in May, but both have since declined as investors adjusted their expectations regarding when central banks will start cutting interest rates. However, it hasn’t damped the longer-term anticipation that London-listed stocks may gain new traction in the next leg of a global equity rally after rate cuts.
Despite ongoing challenges such as sticky inflation and political uncertainty on both sides of the pond, small caps as an asset class are becoming more attractive, especially for contrarian investors with a long-term approach.
There are more than a handful of young companies that exhibit exceptional growth potential and unique market positioning, bolstered by truly innovative products and strong leadership teams. These hidden gems can offer substantial upside potential, you just have to find them and as always, #DYOR.
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This content is intended to highlight current market conditions and should not be considered advice, an endorsement, or a recommendation, nor is it intended to serve as impartial investment or fiduciary advice.
