Not everyone is getting in on the rally.
The stock market has bounced in the last week and a half, but smaller market value stocks have underperformed. The issue is that interest rates are set to remain high for at least the next several months—a problem for the entire equity market.
First, a bit of context. The
S&P 500
has gained 0.8% since hitting a low on Aug. 17. The index’s mild relief rally has continued, with Federal Reserve Chairman Jerome Powell’s Friday speech at the Jackson Hole economic symposium not explicitly mentioning further interest rate hikes which would be intended to help lessen demand and inflation.
The 10-year Treasury yield, which is currently hovering around 4.2%, also remains below the multiyear high of just over 4.3% that it hit in early August. The yield stabilizing is good news for a stock market which is looking for a still-growing U.S. economy to remain resilient.
Less optimistic market watchers, though, might point to the relatively poor performance of stocks with small market capitalizations.
The
S&P 600
index, which consists of smaller market value companies, has been about flat since Aug. 17—but if the market were fully optimistic about growth, it would be outperforming. Improving economic growth tends to give smaller companies’ earnings a larger boost than those of larger companies. This is because smaller firms often have more interest expenses and other fixed costs, so when sales rise, profits rise more rapidly.
However, interest rates are likely to remain high for some time, which should hold back economic and profit growth. While his speech was vague, Powell said that monetary policy likely needs to remain restrictive for a while to get inflation down—code for the fact that the Fed will likely keep interest rates at elevated levels for some time.
The kicker, though, is that higher rates dent the economy on a delay. The fact that the U.S. economy has maintained above 2% growth in the first quarter of this year—which is almost unchanged from the fourth quarter of 2022—might mean that the growth can only slow down from here.
“I do think the economy will slow in the coming weeks,” says Sevens Report’s Tom Essaye. “The longer rates are still at these levels, the longer a lid it will put on growth.”
The point is that one shouldn’t get too excited about the stock market’s recent strength. Small-caps serve as a key signal.
Write to Jacob Sonenshine at [email protected]
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