This week's drawing takes up one of the best-known old memes on the networks, based on a shot by Spanish photographer Antonio Guillem. It shows the "distracted boyfriend" (the name of this popular photo), who in this case takes the form of an investor, turning away from the Nasdaq in favor of American small caps, whose performance is measured by the Russell 2000 index.
Small and medium-sized listed companies have recently enjoyed renewed interest. Why is this?
- Firstly, because U.S. central bank rates are set to fall in September. Indeed, these smaller companies are more exposed to floating-rate debt than large caps: over 45% of the debt of companies listed on the Russell 2000 is floating-rate, compared with 10% for the S&P500 (UBS data).
- Secondly, because election years are historically favorable for them. Investors remember Donald Trump's previous term. By the end of 2016, when Trump had been elected, the Russell 2000 had gained 14%, compared with 5% for the S&P500 and 1% for the Nasdaq. At the time, the NFIB small business optimism index had flirted with record highs shortly after the election, as business leaders hoped for measures in their favor.
- Last but not least, small and mid-cap listed companies enjoy attractive valuations overall, with a discount of some 30% to large caps (BofA data - "Is it time for small caps to shine?", Sebastian Raedler, July 19, 2024).
However, the idyllic picture of a rush to mid caps in the event of a confirmed rate cut needs to be qualified.
- Firstly, because more than a third of the companies in the Russell 2000 are currently unprofitable (around 700 companies).
- Secondly, because the economic context is tepid, since the momentum of Russell 2000 earnings forecasts has "slowed considerably" compared to that of the S&P500 in recent quarters (UBS data - "All the small things: Does this small cap 2.0 rally have legs?", Maxwell Grinacoff, July 18, 2024).
- Finally, because rate cuts have historically not really led to rotation in small and mid caps, despite what the current mainstream would have us believe. UBS has modeled the Russell 2000's performance before and after the first rate cut in a cycle since 1978. Here's what it looks like in graph form:
The UBS illustration shows that the Russell 2000 has, historically, lost ground in the 252 trading days following the first rate cut (252 trading days = 1 year of 365 days).
UBS, which includes these caveats in its aforementioned study, nevertheless points out that, despite the negatives, "the rotation towards low-quality stocks may continue if the rate cuts remain integrated by the market and if the buoyant Trump 2.0 trend continues ahead of the US elections".
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