Source: Zhitong Finance
Expectations of interest rate cuts continued to cool down, disrupting the market's long-awaited rebound in small-cap stocks; short positions held by hedge funds reached one of the highest levels in history.
The overall price of US small-cap stocks can be said to have fallen to near the lowest point in recent years, but since it will have huge debts of more than 500 billion US dollars in the next 5 years, the Federal Reserve needs to send an important risk appetite signal, that is, accurate expectations about interest rate cuts, to attract investors to continue to invest their capital in small-cap stocks. Expectations of interest rate cuts have continued to cool down recently, the market's long-awaited rebound in small-cap stocks has failed to occur, and the short positions held by Wall Street hedge funds have reached one of the highest levels in history.
According to data compiled by the agency, companies that are part of the US small-cap benchmark index, the Russell 2000 Index, hold a total of up to 832 billion US dollars in debt, of which 75% (or 620 billion US dollars) will need to be refunded before 2029. By contrast, less than 50% of the total debt due at the time of the companies included in the S&P 500 Index (S&P 500 Index), the benchmark index for US stocks.
Refinancing risk — small-cap companies account for a relatively large share of the size of debt due in the next five years
Marija Veitmane, a senior multi-asset strategist from State Street Global Markets (State Street Global Markets), said: “Although the valuation is very attractive, we are not going to buy it yet.” “We don't like small-cap stocks because they are much more sensitive to the extent of the economic slowdown, and the cost of financing is much higher, and margins may be squeezed on a larger scale.”
In particular, smaller companies often have significant amounts of variable interest debt, usually in the form of loans, because they are often not large enough to borrow money on the bond market. This means that their interest expenses are usually readjusted soon after the Federal Reserve raises interest rates, and large companies holding fixed-rate bond debt may have to wait longer before the Fed's interest rate hike policy will have a significant impact on their borrowing costs.
Furthermore, the share price performance of small businesses is often closely related to the overall performance of the economy. As a result, Wall Street investment professionals are generally skeptical about “buying the riskiest” small-cap stocks — even when valuations seem very low, as changing and uncertain economic conditions are the subject of the current market.
According to some data, the market sales ratio index of the Russell 2000 index compared to the S&P 500 index is close to its lowest level since 2003, not including the trend of bottoming out during the global COVID-19 pandemic in 2020. However, market participants still said that the price of the index is currently perfect, and requires a strong recovery in economic growth to trigger a major rebound in small-cap stocks.
“There's a reason why larger companies with higher fundamentals are more expensive,” said Guy Miller, chief market strategist at Zurich Insurance. “They often don't have any financing issues and are relatively less dependent on interest rate policies.”
The underperforming performance of small-cap stocks
Since this year, the Russell 2000 Index, which is the benchmark for small-cap US stocks, has only risen 1.6%, mainly because interest rate market expectations of the Fed's interest rate cut have cooled sharply recently. Expectations for interest rate cuts have cooled sharply from expectations of six interest rate cuts totaling 150 basis points in January to 25 basis points of interest rate cut only once.
However, the S&P 500 index, which has focused on large-cap stocks since this year, has risen 9.5%, and experienced a major correction during April due to cooling expectations of interest rate cuts. However, for a long period of time, the performance of small-cap stocks has lagged behind that of large-cap stocks. Since the beginning of 2023, the S&P 500 index's growth performance has been more than double that of the Russell 2000 index.
In fact, according to data compiled by the agency, the small-cap index hasn't broken through previous highs for two and a half years — the longest since the global financial crisis. On the other hand, the S&P 500 index set and broke 22 record highs in 2024.
The main challenge facing small-cap stocks right now is interest rates and economic trends, because US inflation is still longer lasting than expected at the beginning of the year, and a resilient labor market makes it difficult to reduce inflation to the Federal Reserve's 2% target.
US stock position data shows that investors generally lack confidence in the stock market rebound that began at the end of April. Investors are flocking back to low-risk, large-cap stocks dominated by the so-called “Magnificent Seven” (Magnificent Seven), and utility stocks, which are thought to be safer in times of economic uncertainty, driving the Bloomberg Magnificent 7 Total Return Index (Bloomberg Magnificent 7 Total Return Index) by about 9% over the past three weeks. In contrast, according to Ned Davis Research data, net short positions on the Russell 2000 Index futures held by hedge funds reached one of the highest levels ever recorded.
Profit data isn't helpful for small-cap stocks either. According to institutional statistics, the total revenue of the Russell 2000 Index constituent stocks may only increase by 0.3% in the first quarter, while the total revenue of the S&P 500 Index increased by 4% during the same period. Strategists Michael Casper and Gina Martin Adams said that the rest of 2024 may see “ups and downs in economic recovery, and this potential trend may cause the Russell 2000 Index to fluctuate along with it.”
An analysis of Wall Street bank Bank of America Corp. (Bank of America Corp.) shows that even if the benchmark interest rate remains at the current level, considering that nearly half of the debt is short-term debt or variable rate debt, the operating profit of small-cap stocks outside the financial sector may drop sharply by about 32% over the next five years.
Small-cap losses seem to be getting worse
Furthermore, small-cap component companies seem to be losing more and more money. According to data compiled by the agency, about 42% of the constituent companies in the Russell 2000 Index currently have a negative earnings per share (EPS) indicator, while in the mid-90s of the last century, this ratio was even less than 20%.
Hugh Grieves, fund manager from Premier Miton US Opportunities', said: “The fundamentals of the companies that make up the Russell 2000 Index are clearly not as good as they were 20 years ago.” “It's true that more companies can go public now, but they've never made a profit, and probably never will.”
But Hugh Grieves is also one of the market forecasters who warned against abandoning all small-cap stocks. The other is David Lefkowitz, head of US stocks from UBS Global Wealth Management (UBS Global Wealth Management). The head of stocks believes that by the end of this year, the Fed's benchmark interest rate will continue to decline, which will support the trend of small-cap stocks, and the expected recovery in commercial activity is expected to turn into stronger profit indicators.
“We're not saying small cap stocks are bad,” said Lefkowitz, who switched to increasing his holdings of the stock in December last year. “Larger companies really did a better job, in relative terms.”
Jill Carey Hall, a strategist from Bank of America, told clients that it makes sense for stock market investors to be “selective” because the energy, materials, and industrial sectors are very limited in their sensitivity to the economic slowdown, and the risk of refinancing is relatively low, and these sectors are very attractive. But it has proven difficult for some investors to accept this.
“Our feeling is that they are waiting for confidence in slowing inflation to gradually increase, and the Federal Reserve will be able to start cutting interest rates at that time,” she said.
For Grieves, the fund manager of Premier Miton, this is probably not a problem with small-cap stocks themselves, but rather that the market has no reason to shy away from tech giants who have always been the big winners in the stock market. “People always think of the Magnificent Seven,” he said. “Once they stop outperforming the market, you'll see fund managers becoming more interested in small-cap stocks.”