Small-Caps: The Zombie Apocalypse Is Coming!
The Problem With The Large to Small Rotation
In late May (and pretty much all of 2023 for that matter), the investment landscape has been dominated by tech stocks. The culmination of that trend recently was NVIDIA’s Q1 earnings report when they talked about the huge potential in AI and the big investments they were making into it. That’s driven the Nasdaq 100 to a 30% gain year-to-date, but those have been driven almost entirely by the FAAMG names.
For now, the AI mania peak may be in. Since Memorial Day, we’ve seen a different market. Value, cyclicals, utilities and even Treasuries to a modest degree have been leading the market again. Small-caps, however, have been the biggest beneficiary of this shift and by a pretty wide margin.
I’ve had a lot of people on my timeline talking about the large-cap to small-cap rotation. After holding up surprisingly well in 2022’s bear market, they’ve been miserable relative to the S&P 500 this year. That is until the past week or two. Once the mega-cap tech trade began to fade, small-caps stepped in to take the lead.
Perhaps this is the trade in the short-term. One could make the argument that the overbought FAAMG rally would eventually result in a rotation out of tech and into other asset classes. I still think the longer-term trade is out of large-caps and into Treasuries & utilities, not small-caps. While small-caps have benefited since Memorial Day, there’s definitely some degree of defensive repositioning happening here. The bulls may want to continue their bullish narrative by seeing what’s going on in small-caps, but the bigger picture still suggests that conditions are unfavorable for risk assets.
Beyond just intermarket relationships, there’s a very logical reason why small-caps might not be the best play. A lot of them simply aren’t going to survive!
Many small-cap companies have been propped up by two things over the past several years - ultra-low interest rates and government stimulus. Prior to the COVID recession, ample liquidity and incredibly cheap lending rates helped ensure that these struggling companies could kick the can down the road on the whole house of cards collapsing. As long as they could fund operations through borrowing, they could survive, even if they weren’t thriving.
Investors were willing to turn a blind eye too. Buying shares of the iShares Russell 2000 ETF (IWM) meant buying companies with potential, but it also meant buying a lot of garbage.
Now, the environment has changed. Those ultra-low lending rates? Gone. All of that government-sponsored liquidity? Disappearing. The conditions that supported a lot of these questionable companies for years are quickly becoming a thing of the past. The companies themselves might soon become the same.
Let’s take a look at the landscape for small-caps.
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