Small cap stocks have been on an incredible run.

But you wouldn’t know it by looking at the Russell 2000. As I’ve said to my audience many times over the last few years, the Russell 2000 is not a good barometer for the small cap market.

How can that be?

Well, unlike major indexes like the S&P 500 and Nasdaq, the “best” companies get kicked out of the Russell 2000 when the index rebalances.

Essentially, when these small cap companies grow and succeed, they graduate out of the index. Investors relying solely on the Russell 2000 are missing out on some of the highest-quality small cap stocks that have room to run.

This would be like if Nvidia (NVDA) went on a monster run and “graduated” to a “mega cap index.” Those owning the mega cap index would be thrilled. But the S&P 500 index would no longer enjoy the fruits of Nvidia’s upward trajectory.

I say this because there are a lot of stocks working in the small cap space.

And one of my recent recommendations has been a top one to own.

The Rate-Sensitive Names Are Rallying
We talked a few weeks ago about where we are in the market cycle.

While no one has all the answers, the Merrill Lynch Investment Clock helps to put the chaotic market into stages: reflation, recovery, overheat, and stagflation…

With inflation back near the Federal Reserve’s 2% target… inflation-adjusted GDP rising around 3% per year… the yield curve uninverting… and the Fed cutting rates, we’re likely in the recovery phase of this cycle.

And that’s great news for small caps, as they are much more “rate sensitive” than other classes of stock. They tend to have higher debt loads relative to their larger counterparts, making them more responsive to changes in interest rates. As borrowing costs decrease, these companies can invest more in growth, leading to potentially higher returns for investors.

And while small caps are sensitive to changes in interest rates, there is a subsector that is even more affected.

And I expect them to continue rallying.

This One Is “Starting” to Work
When keeping my ear to the ground for opportunities to take advantage of where we are in the market cycle, I narrowed it down to rate-sensitive sectors like…

  • Real estate
  • Consumer discretionary
  • Financials.

And Upstart Holdings (UPST) falls squarely into this category. Upstart is a fintech company that uses AI and machine learning to assess credit risk and underwrite loans. Its technology aims to improve the traditional FICO-based lending model by incorporating a wider range of data points, such as education, employment history, and other nontraditional factors.

The company’s core business thrives when rates are lower. Upstart leverages AI to assess creditworthiness and has disrupted traditional lending by allowing more borrowers to qualify for loans – especially in a falling-rate environment.

Lower rates should be a boon for Upstart’s business. When rates drop, borrowing becomes cheaper for consumers, leading to increased loan demand.

For example, during times of low rates, a borrower with a thin credit file may qualify for a personal loan based on their education or job history – factors traditional lenders might overlook. This boosts Upstart’s loan volume, revenue, and overall performance in a falling-rate environment.

This is a key reason analysts are optimistic about the earnings picture for Upstart. In fact, Wall Street expects earnings growth of 30% per year as the company reaches its “breakout” to profitability by the end of next year.

And while it doesn’t have to do with the company’s rate-sensitive nature, I also like how the stock is heavily shorted. The combination of a lower rates tailwind and a short squeeze was too appealing to pass up.

Considering the stock is up 65% in a little over a month, I’d say my timing was impeccable.

— Robert Ross

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Source: Total Wealth