Rising Rates in Focus as Small Caps Retreat Below 200-Day Average
This article was originally published on ETFTrends.com.
For much of 2018, small cap equities have been the little engines that could, but recently, their large cap brethren has overtaken them as investors may be pivoting from a growth-oriented portfolio to that of a value-dominated portfolio that primarily includes large capitalization equities. One reason may be rising interest rates, which have historically benefitted small caps, but the amount of leverage held by small cap companies could be a cause for concern.
In the last three months, small caps, evidenced by the Russell 2000 in the chart below, have also fallen under their 200-day moving average in addition to lagging behind the large caps found in the S&P 500.
“One of our biggest concerns around small-caps is their leverage,” said Jill Carey Hall, senior equity strategist at Bank of America Merrill Lynch. “That is now increasingly in focus given rising interest rates.”
Related: Rising Rates: What to Watch in Markets
Additionally, rising benchmark yields have been front and center as of late after last week's ascent in key government debt yields like the 10-year and 30-year note. The concern is that in conjunction with higher rates, rising yields could increase the cost to fund smaller companies.
“Despite higher interest rates typically being good for small-caps, leverage is very elevated and some investors may worry that (high-yield bond) spreads widen, which could raise the cost of funding for smaller companies," said Bryan Reilly, a managing director at CIBC Private Wealth Management.
This, however, doesn't mean investors should shy away from adding small caps into their portfolios or add ETFs that focus on the small cap space, such as the iShares Russell 2000 ETF (IWM) . Leuthold Group Chief Investment Strategist Jim Paulsen noted that historically, large caps and small caps eventually revert back to the mean and when one lags, the other eventually catches up.
“One thing that would work as a result that I would argue from this is that if large (caps) have done well for a while, buy small,” Paulsen told Barron’s. “If small has been good for a while buy large. And that’s been a really good approach for the last 15 years.”
“Because of how long this cycle has gone, and with rates going up, people are becoming more risk-averse,” said Paulsen. “So people move to the popular, performing names, and feel good in those, which in part reflects some of their anxiety.”
For more investment strategies, visit the Rising Rates Channel.
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