What Does the Small-Cap Selloff Mean for Markets?

What Does the Small-Cap Selloff Mean for Markets?

By the time you read this, you already know that equities of all market caps have been selling off viciously. Why then the question about small caps? The small-cap selloff actually preceded the overall market selloff and it caught our attention.

What gives? And why have large-cap stocks followed it downward?

The Effect of Interest Rates

Earlier this year a number of market participants foretold good things for small-cap stocks. A strong economy and relative insulation from foreign tariffs have certainly helped their outperformance. At the end of August, iShares core small cap ETF, ticker IJR, was up 16.7% for the year. Then, it started selling off, even while the S&P 500 advanced to new highs. Now its YTD return is approximately 2.7% — a drop of 14% in just a little over one month.

37% of companies that make up the Russell 2000 have not made any money in the past 12 months.

There is a correlation here with a sudden increase in bond yields. Bloomberg comments that 37% of companies that make up the Russell 2000 have not made any money in the past 12 months. This is the highest proportion in eight years. When money is cheap (i.e., low-interest rates) and the economy is strong, investors are willing to pay for tomorrow’s prospects of profitability. As a result, PEs rise, and even unprofitable companies get bid up. Small cap stocks outperform. However, when the Fed raises interest rates to keep the economy and inflation in check, it eventually slows the economy down, which will hit these small companies hard.

Therefore, when interest rates spike higher, small-cap investors get spooked and head for the exits.

What Does This Mean for the Broad Market?

Typically, rising interest rates in a strong economy is not a reason for panic. A strong economy can handle rising rates. Strong companies with healthy balance sheets can continue to perform well despite the fact that borrowing costs have risen. Also, this year, many companies have benefited from tax reform which puts more money back in their pocket to offset higher borrowing costs.

Companies that are profitable can use their cash flow to pay for growth and/or capital expenditures, not relying so much on debt or bond issuance.

Why then are stocks selling off so much? Well, rising interest rates definitely do affect the companies that rely on debt financing and it foretells an eventual economic slowdown. In general, it serves as a reality check for many companies that may have low or no profitability.

Look at some companies who have not yet achieved profitability that have been crashing down to earth hard this week: TWLO $87 to $68; SQ $99 to $69; TEAM $96 to $78; just to name a few.

The fact is that there has been some froth in the market. The selloff is punishing these firms the most. Yet others have also been affected to a lesser degree.

The Best Approach Going Forward

At this point, with interest rates continuing to rise along with a strong economic backdrop the lesson is clear – stick with names that have strong balance sheets and do not depend so much on debt financing and an overly optimistic economy. Companies with large cash reserves and strong profitability will continue to do well in this market.

At Aspen, we look at the fundamentals and the technicals for our trade ideas. We will continue to recommend trades that give us our best chance for success by evaluating all of these ever-changing factors.

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