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Small-Cap Stocks Lead Market Slump. Might They Rebound?

Small-capitalization stocks have fallen further than the large-caps this year amid concern about the Federal Reserve raising interest rates.
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Small-cap stocks are leading the equity market down amid higher bond yields and anticipation the Federal Reserve will begin raising interest rates soon.

The Russell 2000 index of small-cap stocks has slid 10% this year, compared with 8% for the predominantly large-cap Russell 1000. 

That’s a turnaround from the first half of last year, when small caps outperformed amid anticipation of steady interest rates and only mild concern about inflation, which hadn’t surged yet.

Rising Rates Hurt Small Caps Particularly Hard

Rising rates hit small-cap stocks particularly hard, partly because many small companies are heavily indebted. These companies have floating interest rates on at least a third of their debt, Lori Calvasina, head of U.S. equity strategy at RBC, wrote in a commentary cited by Bloomberg. That means interest payments on these companies’ debts are headed higher.

Rising rates also hurt by making safer investments such as bonds look attractive compared with stocks of small companies that may not see profits for years.

Indeed, unprofitable companies account for 31% of the Russell 2000, compared with 5.7% for the Russell 1000, according to Jefferies, as cited in The Wall Street Journal.

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“The non-earners are the riskiest of risky stocks,” Steven DeSanctis, small- and mid-cap strategist at Jefferies, told The Journal. “These stocks generally do awful, very poorly, in front of a Fed hike.”

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With consumer prices soaring 7% last year, many analysts and investors expect the Federal Reserve to raise interest rates four times this year, beginning in March.

In the Russell 2000, the stocks of companies that are unprofitable have dropped more than the index as a whole this year, DeSanctis said.

Might Small Caps Rebound?

Last week, RBC Capital Markets said that its confidence in small-cap stocks is ebbing. “We aren’t ruling out a catchup trade by small caps in early 2022. But we’re no longer counting on it,” said RBC’s Calvasina, according to Bloomberg.

“We think a better way to play the early 2022 rotation [to value stocks from growth stocks] is through large-cap value or cyclical sectors.”

But some strategists say small-cap stocks may be poised for a rebound, Reuters reports.

"It's been a bloodbath for small caps," Jefferies’ DeSanctis told Reuters. "The average small-cap stock is down about 40% from its 52-week high."

That doesn’t mean small caps can’t full further, but "this is part of the bottoming-out process," DeSanctis said. “Valuations are getting a lot cheaper. Earnings are holding up. I can't see it getting a lot worse from where we are today."

The Russell 2000 has fallen to the point that investors are pricing in recession DeSanctis said. But he sees that as an unlikely outcome.

Jill Carey Hall, an equity and quantitative strategist at Bank of America Securities, hasn’t given up on small caps. "Most of the worst could be behind us," she wrote in a commentary cited by Reuters. Investors should "stick with small," she said.