People keep telling me small cap stocks are unloved.
And there is some truth to this. The bull market we’ve seen over the last 18 months has been driven primarily by “mega cap” stocks like Nvidia (NVDA), Microsoft (MSFT), and Alphabet (GOOGL).
Small caps have yet to join the party. This is a key reason the Russell 2000 – the key small cap index – recently hit a 20-year low relative to the S&P 500.
We can thank higher interest rates and lower earnings growth for this underperformance.
But from what I’m seeing, the trend is about to reverse.
That means now is the time to start buying this unloved sector.
Small Caps Had an Earnings Problem
Stocks are priced based on their earnings.
Whether it’s the expectation of how much a stock will grow in the future… or its previous earnings performance… earnings and the “earnings multiple” are the keys to understanding what drives stock market returns.
Historical data supports the correlation between earnings and stock prices. A comprehensive analysis conducted by Research Affiliates, a leading investment advisory firm, found a strong positive relationship between earnings growth and stock returns over the long term.
And unlike the megacap tech stocks, small cap stocks have not been growing their earnings over the last year.
In fact, Goldman Sachs says 31% of Russell 2000 stocks had negative net income in the latest quarter compared to 0% for the S&P 500…
Source: Goldman Sachs
However, there’s a good chance this dynamic – which has put a lid on small caps over the last year – is about to change.
And it all has to do with the Fed.
Small Caps Love Lower Rates
Small cap stocks are much more sensitive to interest rate cuts than large cap stocks.
Think of it like this: Small-cap companies are like young plants that need more water to grow, while large-cap companies are like mature trees that can survive with less. When the Federal Reserve cuts interest rates, it’s providing that much-needed water to young plants, giving them a boost to grow faster.
For small-cap companies, lower interest rates reduce their borrowing costs, allowing them to invest more in growth opportunities, expand operations, and improve earnings growth.
These companies often rely more heavily on external financing compared to large-cap companies, so the impact of lower rates is more pronounced.
That means when the Fed cuts rates, small cap stocks will experience a more significant boost in performance.
And from everything I’m seeing, rates are about to come down significantly.
Rates Are “Definitely Maybe” Coming Down
Talk of the Federal Reserve cutting interest rates was all the rage going into 2024.
In January, investors had priced in seven cuts for 2024. Yet at the halfway mark, we’ve seen zero rate cuts in the U.S.
But it’s clear the path for interest rates is lower.
For instance, last month no central bank hiked rates for the first time since October 2020.
Rates are not going any higher globally. In fact, the trend is strongly LOWER for rates as inflation wanes globally.
And investors are starting to price in this reality. There is now a 75% chance the Federal Reserve lowers interest rates at its September meeting…
Source: Bloomberg
In addition, Citi Group expects the September rate cut to kick off a major interest rate cutting cycle.
In fact, the bank forecasts the central bank will lower interest rates eight times over the next 12 months…
These lower interest rates will benefit small caps. Since small caps are far more dependent on borrowing money to fund operations, lower interest rates – especially significantly lower rates like Citi Group expects – will be a massive boon for small cap earnings as interest expenses fall.
And since lackluster earnings growth is the main reason small caps have underperformed, I’m expecting a powerful rally from this unloved sector.
So, while mega cap tech stocks are getting all the investor attention right now, I expect the pendulum to swing back to small caps over the next six months.
That’s why I’ve been recommending our Breakout Fortunes members add to a few high-conviction small cap stocks over the last few weeks.
Make sure to keep small caps on your radar.
Because the future is looking bright.
— Robert Ross
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Source: Total Wealth