Prices of small-cap stocks remain significantly adrift from their historical performance at the onset of a Fed hiatus, now offering a golden chance for value seekers. While a new study hails the performance small-caps during Fed pauses, critics cast doubt and warn that this historical trend is difficult to time precisely.
Since the Federal Reserve last raised interest rates in July, renowned small-cap indices such as the Russell 2000 and the S&P 600 have diminished by more than ten percent in value. Both indices are trailing their levels at the commencement of this year.
This downturn is striking given that the initial stage of an interest rate halt by the Federal Reserve has customarily been the prime time to invest in small-cap stocks, asserts new research spearheaded by Derek Horstmeyer, a finance professor at George Mason University.
Horstmeyer scrutinised the yields of diverse asset classes during six instances over the past fifty years when the Federal Reserve ceased hiking interest rates, and rates stabilised for a trimester or longer—a scenario that has re-emerged since October 2023.
Historical trends
Small-cap stocks witnessed the most substantial advances on average: 27.6 percent during the first half of an interest rate pause. This growth then tapers to 3.5 percent in the latter half. In contrast, fixed-income instruments yield an average annualised return of 8.25 percent in the initial half of a plateau, decreasing to 6.13 percent thereafter, Horstmeyer wrote in The Wall Street Journal, advocating for a prompt pivot to small caps.
The study, yet to encompass the outcomes of the current interest rate pause, is anticipated to be published later this year by the university. A decline in returns among small-cap listed companies during an interest rate pause has been a rarity, occurring only once before, Horstmeyer notes.
When precisely is ‘half the pause’?
Yet, while in hindsight it is relatively straightforward to delineate the first from the second half of the plateau, pinpointing this during the hiatus is nearly infeasible for investors, comments Lukas Daalder, an investment strategist at Blackrock. He challenges the statistical significance of the findings and references past scenarios where interest rates saw sharp fluctuations amidst seeming pauses.
“In March 1980 we reached a zenith of twenty percent, by June we dipped below ten percent, and come January we were at twenty percent again. Was that a plateau, how long did it endure, and where was the midpoint?” Daalder questions. In 1988, the Fed similarly paused temporarily before resuming its activity. “Who’s to say we aren’t in a similar phase now?” he probes.
For the moment, the market is not banking on a recurrence of such fluctuations. Presently, interest rate derivatives are signalling that the Federal Reserve will trim interest rates by 25 basis points come June 2024, suggesting to the market that the apex of the plateau around the year’s end is past.
“If we’ve reached the pinnacle of capital market interest rates—which are determined by the market as opposed to the Fed’s target rate—interest rate-sensitive investments that have underperformed thus far, such as possibly small-cap stocks, will begin to fare better,” Daalder argues, adding that “a long duration bond will undoubtedly exhibit the most direct correlation to the interest rate peak.”
Optimism
“If investors are prepared to counter the current and invest long-term, despite volatility, now is an opportune time to selectively invest in small stocks,” Ritu Vohora, an investment specialist at T. Rowe Price, believes.
Small companies account for roughly twenty percent of global market capitalisation but represent about seventy percent of the total number of companies, and are presently “remarkably inexpensive,” Vohora comments.
At Optimix, there’s a cautious optimism for small listed companies, tempered by the recent surge in interest rates. Jelte de Boer, managing director and investor at the asset manager, emphasises selectivity in their small-cap stock investments. Anticipating less robust economic growth in 2024, they favour small firms in growth markets with minimal debt and high returns on assets.
In addition to small-cap stocks, Optimix is banking on short bonds and stocks less sensitive to interest rates, such as those in the energy sector. In a multi-asset portfolio, they are advocating an above-average position for short bonds in the forthcoming year and selective equity investments. Small-cap and dividend stocks are expected to outperform in the upcoming year, despite prior downturns, akin to their expectations.
Corne van Zeijl, a strategist at Cardano, posits that if interest rates have reached their peak, small-cap stocks will likely excel. Although a gentle economic deceleration is the prevailing forecast, he contends that the anticipated economic slowdown—and a probable recession in the US next year—has already been priced into small-cap stock valuations.