Small businesses often show a greater degree of sensitivity to higher interest rates and economic conditions than larger companies, because they typically face a higher level of debt and rely more on bank financing to run their businesses.
In addition, small businesses are often more focused on the domestic market than larger companies, which makes them struggle when inflation or a faltering economy weighs on American consumers.
Small cap stock performance over the decade
From August 1, 2014, through August 1, 2024, the Russell 2000 Small Cap Index has delivered an annualized return of 8.91 percent, compared with a return of 15 percent for the S&P 500 Large Cap Index.
For the current year, since the beginning of 2024 until August 30, the S&P 600 index for small-cap stocks and the Russell 2000 index for small-cap stocks rose by 8.4 percent and 10.4 percent, respectively, while the S&P 500 index achieved a return of 19.5 percent.
According to a report prepared by the Wall Street Journal and reviewed by the Sky News Arabia Economy website, Nick Kalivas, head of exchange-traded fund strategy at Invesco, says that small companies have been lagging behind for a decade, as they have been hurt by inflation and rising interest rates in USwhich prompted investors to ignore it.
Over the past few years, the “Great Seven” stocks with huge market capitalizations, i.e. Amazon Alphabet, Meta, Apple, Microsoft, and…Nvidia andTeslaOn small-cap stocks, which have a disproportionate influence on the Nasdaq Composite and S&P 500 indices, where outstanding financial performance and continuous innovation, especially in the field of artificial intelligence and advanced technology, and other areas with high growth potential, attracted many investors to giant companies, which contributed to enhancing their growth and influence in financial markets.
Small cap companies are now selling at historically low valuations compared to almost every other stock group, but analysts and investors are increasingly optimistic about their ability to outperform large companies in the coming months, driven by the possibility that they will not fall, according to the Wall Street Journal. USin recession and interest rates down by up to 1.5 percentage points by the end of 2025.
According to Wall Street analysts’ earnings estimates, the S&P SmallCap 600 is expected to see earnings growth of 22.1% in 2025 versus 14.8% for the S&P 500, says Sam Stovall, chief investment strategist at CFRA Research.
“Small cap companies are cheap right now, so it’s a good time to buy,” said Mike Palmer, managing director of Ark Royal Wealth Management. “For many investors, it may seem like a reverse play, as the ‘Magnificent Seven’ stocks continue to support the market, but the rally in these companies may not last forever.”
Investors have already started buying into small-cap stocks, with small-cap exchange-traded funds taking in a net $25.1 billion in the first eight months of 2024, nearly three times the $9.4 billion invested during the same period in 2023, according to data from financial services firm Morningstar Direct.
Financial markets strategist at First Financial Market says: Jad Hariri, in an interview with the “Sky News Arabia Economy” website, said that after the establishment of US Federal Reserve With interest rates set to rise to 5.50 percent in a short period of time, markets are now preparing for the start of a rate cut.
Market expectations indicate that the Federal Reserve may cut interest rates by 100 basis points between now and the end of 2024, with the cut expected in September to be 50 basis points, indicating that this expected cut is a result of rising unemployment rates and a decline in non-farm payrolls data. AmericaThis reinforces fears that the country’s economy could face a recession, especially since unemployment rates in the United States have risen above 4 percent during the past three months, while inflation has declined to 2.5 and 2.6 percent.
What determines market trends?
According to Hariri, while the markets expect a 50 basis point interest rate cut in a few days, the US Federal Reserve may surprise with a 25 basis point cut, while a 50 basis point cut would mean that it is sending a message to the markets that there is an unannounced glitch occurring.
He added that there is a problem that is very important to address, which is that determining the direction of the markets in the next stage will not be related to the rise or fall in inflation levels, as the markets are currently focusing on the possibility of a recession occurring in US economy In addition to unemployment rates, from this standpoint, lowering or raising interest rates will have no relation to the rise or fall of stock prices.
Hariri added that everyone realizes that large companies, which some describe as “too big to fail,” regardless of what happens to the American economy, may see some corrections, but small companies are more affected because they do not have financial solvency or high liquidity compared to large companies. He pointed out that small companies only operate locally, while large companies operate globally and locally, and therefore the possibility of a recession in America, and the economy suffering from difficult conditions, will affect small companies first and then large companies, which are less affected.
Hariri believes that small company stocks will not necessarily rise if interest rates are lowered, because once interest rates start to decline, markets will start pricing in an economic recession. Therefore, the advice given to investors in this case is to wait for the events of the fourth quarter of this year to see which direction the markets will take. He stressed that there is no link between lower interest rates and the rise in small company stocks, as the markets’ pricing of an economic recession and the decline in industrial activity are the two factors that affect the markets.
According to a Wall Street Journal report seen by Sky News Arabia Economy, given the challenges of buying small-cap stocks, financial advisors warn that these companies pose unique risks and costs for individual investors. According to Bill Hinch, portfolio manager at First Eagle Small Cap Opportunity Fund (FESCX), small-cap companies are more volatile than large-cap companies and are less liquid, so trading them can be expensive.
Financial advisors stress that individuals should keep in mind that ETFs offer a different approach to investing in small-cap companies. For example, the $11.8 billion iShares Russell 2000 Growth ETF (IWO) focuses on stocks of companies that have shown better-than-average earnings gains and have high potential for earnings growth, while the $30.1 billion Vanguard Small-Cap Value ETF (VBR) focuses on undervalued companies with good fundamentals.
There are also a variety of other investment styles that small-cap ETFs use, such as momentum trading and dividend investing.
Kevin Gordon, chief investment strategist at Charles Schwab, notes that 40 percent of the stocks in the Russell 2000 are non-profitable, so examining profitability is important if you want to invest in small companies. Also, if a company has debt, you should examine its ability to cover high interest rates, since a significant decline in interest rates will take time.
Ultimately, investing in small-cap stocks is actually a long-term investment and it may take some time to see big gains, says Robert Harvey, a chartered financial advisor and vice president at Dimensional Fund Advisors, an investment firm known for investing in small-cap stocks that applies academic research to market behavior.
