While small-cap stocks (Russell 2000) were showing relative strength throughout much of 2018, their recent weakness in both September and October has led to underperformance versus the S&P 500.
Table 1 looks at major index total returns for September, October, the year to date through Oct. 5, as well as the three-year annualized change for each index.
TABLE 1: COMPARISON OF RECENT/THREE-YEAR MAJOR INDEX RETURNS
Source: Market data
The Russell 2000 was trading at oversold levels as of Oct. 5 (see Figure 1).
FIGURE 1: SMALL-CAP RUSSELL 2000 (1-YEAR TREND)
Source: Bespoke Investment Group
Bespoke Investment Group noted the performance discrepancy between large and small caps last Friday (Oct. 5):
FIGURE 2: S&P 500 DECILE PERFORMANCE BY MARKET CAP (OCTOBER 2018)
Source: Bespoke Investment Group
One school of thought holds that rising interest rates adversely impact small-cap stocks because smaller companies are usually more dependent on shorter-term financing and adjustable-rate loans than large caps. Further, the argument goes, the larger dividends generally paid by large-cap companies enhance returns on a relative basis versus small caps—an important factor when bond yields improve.
There is a counterargument, says Investopedia, that should benefit small caps in a rising-rate environment. In a 2016 article quoting Sam Stovall, U.S. equity strategist for S&P Global Market Intelligence, they wrote,
An August 2018 article in Seeking Alpha made the quantitative case that returns for small-cap stocks do not necessarily suffer during rising-rate environments—in fact, they outperform. Francis Gannon, Co-CIO at Royce & Associates, wrote,
FIGURE 3: SMALL CAPS VERSUS LARGE CAPS IN RISING-RATE ENVIRONMENTS (1998–2018)
Source: Seeking Alpha, “What Rising Rates Mean for Small-Cap Stocks,” August 2, 2018.
On a broader basis, when should investors start to worry that higher interest rates will have a significant impact on their overall stock holdings?
An April 2018 article from U.S. News and World Report offered a positive equity perspective for the current interest-rate environment and suggests there is a long way to go before rate increases become an issue for stocks—but suggests caution as well when relying on historical trends:
The opinions expressed in this article are those of the author and do not necessarily represent the views of Proactive Advisor Magazine. These opinions are presented for educational purposes only.
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