As Tesla and Alphabet’s disappointing earnings lead to a sell-off in the “Magnificent Seven,” small-cap stocks are experiencing a resurgence. But is this “The Great Rotation” or just a speculative bubble? Investment Officer gauges the sentiment.
“The Great Rotation is a generational event,” CNBC headlined last week. The usually reserved Wall Street Journal called the renewed interest in small-cap stocks a “rotation of historic proportions.”
Despite small-cap companies typically carrying high debt and often operating at a loss, strategists from Deutsche Bank, BNP Paribas, and Neuberger Berman believe small-caps are poised for strong performance in the near future.
“The current movement suggests this is indeed a historic rotation,” said Simon Wiersma, Chief Strategist at ING, to Investment Officer. He is “reasonably certain” that this is a long-term shift towards smaller stocks.
The numbers support this view. Since the last record in July, the Magnificent Seven have lost approximately 11 percent due to worse than anticipated quarterly results from Alphabet and Tesla. Conversely, the Russell 2000 index, which tracks US small-cap stocks, has risen roughly 10 percent since early July.
The rapid rise in small-cap stocks forced hedge funds betting against them to quickly close their short positions, a phenomenon known as a short squeeze.
Interest rates
Good news for small-caps, which are highly sensitive to interest rates, came with the latest Consumer Price Index (CPI) release on 10 July. The CPI fell by 0.1 percent in June, slowing the annual increase to 3 percent. Core inflation eased from 3.4 percent to 3.3 percent annually. The two-year yield dropped from 4.63 percent to 4.38 percent.
The probability of a US interest rate cut of at least a quarter percent in September has risen to over 95 percent, according to the CME FedWatch Tool. A rate cut would be a relief for small-cap companies, which typically carry high debt loads, making small-cap investors optimistic.
The key question is whether the market’s prediction of the Fed’s rate path is accurate this time. Additionally, the economy must remain robust to ensure the traditional outperformance of small-caps at the start of a new economic cycle.
Despite the risk of the market misjudging rate cuts, Wiersma believes small-caps are currently well-valued globally, especially in Europe where valuations have lagged.
“In the United States, small companies’ profitability is somewhat disappointing, making a rate cut even more crucial there,” he said. As much as 40 percent of the companies in the Russell 2000 are unprofitable.
The Russell 2000’s peculiarity
The profitability of American small-caps is problematic, said Marco Pirondini, CIO of Amundi US. While he agrees that a rotation to small caps can be wise at the start of a new economic cycle, he points out the peculiarity of the Russell 2000, which includes many “zombie companies” that have survived thanks to years of monetary easing and zero interest rates.
“Many of these companies will struggle to refinance their debt over the next five years, especially if the economy weakens,” he said.
Pirondini finds it safer to stay in large-cap stocks, especially for passive investors. “In the large-cap universe, it’s hard to find companies not in good shape. Their balance sheets are strong, and they are generally profitable,” he said.
He understands why investors are moving away from the Magnificent Seven, viewing the rotation more as a response to the high concentration of large tech companies in the S&P 500 index than an attractive small-cap universe. The Magnificent Seven account for about 30 percent of the S&P 500 index.
Pirondini suggests investing in an equally weighted index to offset the decline of large tech companies with the rest of the S&P 500. “However, as an active investor, I prefer picking companies myself. There are very interesting investment opportunities in the US, especially in the financial, energy, materials, utilities, and pharmaceutical sectors,” he said.
Wiersma is more optimistic about the future of large tech companies in the US. According to ING, the major correction is already behind us. “Earnings expectations remain particularly strong and will likely continue,” he said. “We are still early in the earnings season, and the results we’ve seen so far have not been as bad as the stock prices suggested,” Wiersma added.
“If you want to invest in small caps now, I would take money out of bonds or cash. I wouldn’t touch other positions to play this trend,” the strategist advised.