With the Federal Reserve now cutting interest rates, investors are looking for stocks that can be super-charged by lower borrowing costs. That has led many investors to look beyond the biggest companies in the world to other parts of the market that have been lagging. The Russell 2000 is one of those places. Despite Thursday’s dip, the small-cap index has been trading near 52-week highs. Small and medium-sized companies tend to be the most closely affected by the direction of the economy and rates. That’s why Russell 2000 had such a tough time as the Fed’s rate hikes in 2022 and 2023 intensified. But that’s also why it’s now getting attention as central bankers chart the course for their easing campaign. .RUT mountain 2022-10-01 Russell 2000 since Oct. 1, 2022 The thinking is that smaller companies have more vulnerable balance sheets and greater needs for financing — so, they see outsized benefits when debt becomes more affordable versus their larger cap peers. There have been lots of analyst research supporting this narrative and investors’ increased appetite goes beyond the large caps. BMO Capital Markets wrote in a note last week: “Although small and mid-cap stocks [SMID for short] have delivered above-average, double-digit gains over the past year, the performance still has been unable to keep up with the torrid pace set by their large-cap counterparts. … We continue to believe that these stocks have been unfairly punished (or ignored) given what we have viewed as a mismatch between the fundamental underpinnings and the relative performance of the group, and nothing has changed in that regard.” The analysts also wrote, “It is only a matter of time before the fortunes of this group take a turn for the better” now that central bankers are cutting rates. Analysts at Bank of America wrote in a Tuesday note: “Clients sold ETFs but bought single stocks. Outflows were seen solely in large caps; small and mid-caps saw inflows.” If money does keep flowing into small caps, will it come at the expense of large caps? At the moment, it would seem there’s been enough money to go around, so we have not had to contend recently with any gut-wrenching rotation out of other parts of the market as we did a few times over the summer. After all, the Russell 2000 isn’t the only index trading at or near long-term highs. The S & P 500 hit another all-time high Thursday. .SPX mountain 2022-10-01 S & P 500 since Oct. 1, 2022 That said, if the move into the smaller caps stocks continues, we may start to see more competition for capital. Given the incredible gains in megacap tech stocks, it’s fair to say that they’ve not been able to do much lately because buyers have focused their buying power elsewhere — be it the SMID caps or larger cap names that are more sensitive to interest rate dynamics. We don’t generally invest in these smaller companies. So, capturing more rate exposure for us comes down to three stocks. We own Stanley Black & Decker , Best Buy and Home Depot because they stand to get a boost from their ties to the extremely rate-sensitive housing market. Certain industrials and financial stocks, which are also in the portfolio , can also see benefits from a normalizing of the bond market yield curve and sustained economic growth. So, do you bail out of the more secular parts of the market like tech that have been huge winders for us and try to play the rotation? Or do you stay the course? The answer does not have to be one or the other. Market timing is difficult and Jim Cramer never recommends it. As long-term investors, we stay focused on finding companies with great long-term fundamentals and ensure that we have some increased exposure to more rate-sensitive plays by maintaining a diversified portfolio. That all leads to concerns that the megacaps may be at risk should a rotation to SMID caps intensify. To that, we ask: Any changes in the fundamentals of the bigger companies that have powered us higher? The answer, in our view, is a clear no. Nvidia CEO Jensen Huang told CNBC earlier this month that demand for the artificial intelligence chipmaker’s new Blackwell platform is “insane” — an assertion confirmed Thursday by Taiwan Semiconductor Manufacturing Company in commentary along with stellar quarterly results. TSMC is the world’s largest third-party producer of semiconductors. Nvidia, along with our other chip stocks Advanced Micro Devices and Broadcom are customers of TSMC. Meta Platforms is already showing gains in engagement and ad targeting thanks to generative AI. Apple Intelligence, the tech giant’s answer to AI, is a about week away from being available on iPhones. And, it appears that demand for Apple ‘s new iPhone 16 is better than recently feared. Amazon , Microsoft and Alphabet — the world’s three biggest cloud providers — are all seeing cloud sales benefit from increased business confidence and generative AI offerings, which do indeed appear to be yielding positive results for their customers. Morgan Stanley’s AlphaWise survey indicates that “companies are seeing ROIs [return on investments] at or above expectation for GenAI solutions they have already launched.” We’re not the only ones who think the megacaps remain attractive from a fundamental perspective. Canaccord Genuity wrote in a Tuesday note, “As investors position for a rate-cutting cycle and the possibility of a rotation out of Mag7 stocks into smaller-cap names (for which there is some precedent), we think it is appropriate to examine the underlying drivers of historical Mag7 outperformance. While sentiment has certainly played a role [in Mag7 performance], this has been very much a fundamentals-driven phenomenon that mostly reflects impressive growth, market share gains, and profitability improvements for these exemplary companies, and most of the companies have benefited from market structure and scale advantages that appear to be intact.” The analysts also wrote, “After examining the individual drivers for each company, our fundamental analysts generally see continued operating momentum ahead, albeit possibly at a slower pace. It stands to reason therefore that any rotation out of these [Mag7] names should be cushioned by elevated fundamentals and still reasonable valuations. Furthermore, our fundamental analysts see continued operating momentum ahead for these names.” Bottom line We plan to stay the course and make small adjustments here and there in the context of a diversified portfolio. We’re not ignoring the rate dynamics and we have several names in the portfolio that stand to benefit. We just don’t think it most beneficial to longer-term gains to exit, or seriously pare down, what have been and all signs continue to point to remaining great investments. We might make small adjustments here and there but think that if you plan to make large sweeping adjustments to your exposure in hopes of catching a move, you’re more likely to leave upside on the table than catch every move bouncing from one group of stocks to another. That’s not to say you shouldn’t look at SMID caps for your portfolio. That’s a decision only you can make. If you do, it’s better to try and identify one or a few great names as BMO Capital Markets suggests. The analysts, in last week’s note, said investors should be “highly selective.” If the economy starts to weaken and things don’t go as smoothly as we think it will, the SMIDs are the ones that will take the hit because they don’t have the balance sheet strength to ride out the rough patches as well as bigger companies do. Shares of small and medium-sized firms are up because they benefit from cheaper debt. But a company that relies on debt to grow — unlike the megacaps that can tap into their monster cash flows — is not where you want to be in an economic slowdown that sparks recession fears. While things are looking better with the Fed cutting rates, there remains a great deal of uncertainty ahead, not the least of which is a U.S. Presidential election less than a month away. (See here for a full list of the stocks in Jim Cramer’s Charitable Trust.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. 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A television station broadcasts the Federal Reserve’s interest rate cut on the floor of the New York Stock Exchange on Sept. 18, 2024.
Michael Nagle | Bloomberg | Getty Images
With the Federal Reserve now cutting interest rates, investors are looking for stocks that can be super-charged by lower borrowing costs. That has led many investors to look beyond the biggest companies in the world to other parts of the market that have been lagging.
