2023-06-26 04:36:16 ET
Summary
- June started off very strong for smaller-cap companies, with the iShares Russell 2000 ETF, surging over 8% in a matter of two weeks.
- Small-cap stocks are often considered the domestic bellwethers of the economy.
- It appears the real bull market is in credit card interest rates, which no doubt is a major driver of overall headwinds for the "small-caps lead the bull market".
June started off very strong for smaller-cap companies with the iShares Russell 2000 ETF ( IWM ) surging over 8% in a matter of two weeks. Narrative followed price, and seemingly every day on financial media was some analyst arguing that widening breath and renewed strength outside of large-cap Tech ( QQQ ) would be the catalyst for the next bull run.
The problem is that the relative strength totally collapsed, ending last week at the lowest relative ratio lows against the S&P 500 ( SPY ) this year. Incredibly, we are back to where the relationship was at the depths of the 2020 Covid Crash. Beneath the surface, the Federal Reserve put small-caps in complete relative lockdown.
Understanding the Importance of Small-Cap Stocks
Small-cap stocks are often considered the domestic bellwethers of the economy. This is primarily because these companies generate most of their revenue from domestic customers. They also have significant exposure to financial stocks ( KRE ), which play a critical role in determining the state of the economy. Healthy banks often indicate a robust economy, hence the stability of these stocks is crucial.
This is incredibly important. Any argument around avoiding or delaying a recession must be priced in more sensitively to small-caps than international large-cap equities ( SPY ). It appears that despite screams of a "new bull market," it's the same old market we saw during the 2020 lockdowns from an intermarket analysis standpoint when looking at market cap.
"But that's not what the breadth argument is about" is not a valid counter. If small-caps stocks rise 2% in a year with all of its ups and downs from start to finish, while inflation is solidly over that, that's a negative return year on a real adjusted basis. It is not enough that they rise. A rising tide that doesn't lift all boats drowns everyone. It's a signal that higher rates are not only having a negative impact, but also fooling investors into taking on concentration risk by "markets" which increasingly are being driven by a very select group of large-cap winners.
It appears the real bull market is in credit card interest rates, which no doubt is a major driver of overall headwinds for the "small-caps lead the bull market" narrative.
Conclusion - A Warning Sign
Are there tradeable opportunities for small-caps? Certainly. But I suspect the stock market can't outrun the cost of capital. And by stock market I don't means the S&P 500. I'm talking about what drives the economy and is a major contributor to employment and economic growth longer-term.
Is there a bull case for small-caps? Certainly. One could look at valuations, overall sentiment, and any other data that confirms the idea that IWM, as a proxy, has overreacted. The IWM/SPY ratio could, for all we know, surge like it did as the reopening and election took place at the tail end of 2020. I remain skeptical though that a new secular bull market can be led by small-caps very long-term given fundamental and consumer deterioration, and that should in turn mean we are not out of the woods as far as risk-off pulses and new broad market highs to come.
For further details see:
IWM: What Happens Next To Small-Caps Is Critical To Bulls And Bears Alike