How do interest rate changes impact small-cap stocks compared to large caps?
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Overview
Interest rates have a significant impact on market results at so many levels. Interest rates determine the cost of capital and sets the capex internal rate of return, the prices companies, especially small caps, pay to borrow money to support GROWTH. Interest rates determine the rate of returns on fixed income. Creditworthiness co-determines access to capital. The sources and uses of capital drive how revenues and income produce profit which ultimately determines the price investors are willing to pay for stocks and provide momentum and support for price levels.
This is an important question for anyone using a factor investing strategy focused based on earning the historically- documented anomalous premia derived through a SIZE (small-cap) and VALUE (cheap) equities. That includes almost all 55 AAII guru/factor investing strategies.
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All 55 of AAII stock screens are based on factor investing - Growth, Value, Quality, Size, or Momentum.
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And interest rates have a huge potential to impact MY factor investing strategy in 2025.
Briefly, my portfolio has evolved into a tripod strategy for 2024. (1) 33% GROWTH factor stocks, (2) 30% SECTOR cyclical stocks, (3) 40% SIZE and VALUE factor stocks, and (4) 7% MMFs.
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Due to recent events - the economy, the on-going monetary policy cycle, and the election, the following "problems" present themselves. (I will ignore the few dozen or so world-wide issues that lurk in the background ready to become spoilers on the whim of world leaders.
Problem #1 is we don't really know what the Fed FOMC will do in 2024. The Fed Chair says "maybe" 2 0.25% cuts in by EOY 2024 or maybe only 1 or maybe 0. This non-committal stance has the potential to FREEZE interest rates and impact investing in small cap stocks (the SIZE factor) or "cheap" stocks (the VALue factor) and downstream (the MOmemtum factor).
QUAlity/PROfitability investing factors have the potential to absorb higher interest rates and benefit in this environment.
Problem #2 is the latest Fed FOMC dot plot says there is a lack of unanimity among the 11 or so votes on what target FFR rate the Fed hopes to achieve to (1) keep inflation in check, AND (2) promote economic growth. This is not a good omen for resolving Problem #1. In fact, it exacerbates #1 to some extent.
Internal tensions over interpretations of economic theory among economists is expected, but their bickering is dangerous.
Problems #1 and #2 create Problem #3 The big institutional investors and hedge funds that COLLECTIVELY dominate about 80% of market volumes (and thus GROWTH and MOMENTUM factors) have tended to ignore the "darker" or at least dimly lit factor investing corners of the market when interest rates are raising UST10s toward 4.75% which makes FI appear relatively more attractive since this raises the "risk free rate" bar for all these 4 investing factors.
And now (as Jackie Gleason used to say) the "really, really, really BIG" problems. "And away we go."
Problem #4 is that in 2024-2028 we have a POTUS who is expecting to restore economic GROWTH and who is not reticent to vociferously and vehemently "jawbone" from using the Truth Social's "bully pull pit." "DT1" posted around 25,000 times. DT2 will only feed this habituation. I'm guessing 100,000 posts is not out of the question.
Problems #5 is the large and rising federal debt AND the debt ceiling is rapidly incurring rising debt service amounts to slake the debt beast. This is not a trivial issue (as economist like to say). This one problem will drive up inflation and will increase pressures on fiscal policy to fund government "entitlement" programs with the Defense budget make up almost 85% of all federal spending. The other 85% is all that's available to "grow" the economy.
Problems #6 is because of Problems #1-#6, there will be only 15% of monetary policy for "discretionary" funds to drive economic expansion.
Problem #7 is that it will take at least 100,000 social media posts AND a cohesive AND cooperative Congress to get fiscal policy under control.
Problems #8 is how Problems #1-#7 interact to produce a favorable economic expansion tail wind to support my factors based portfolio.
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These are my troubles. You are on your own to identify and confront yours.
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I leave you to ponder this real-life lesson.
I used to attend a 8AM Friday Bible study class for businessmen. We do that in Texas.
One morning, a member gave this testimony.
First, he had lost a few million that week. We all groaned in sympathy.
Then he placed his business card in a collection plate and passed it around with these instructions:
Take out your business card and write your BIGGEST problem on the back. We all did as he requested.
Then he will pass the plate to collect all the cards.
When he got the plate back, he said he would pass the plate around again.
This time he asked us to take a card --any card but our own.
He closed by saying: When we see how large the problems of OTHERS are, we will want our problems back
Thus, endth the lesson.
Regards, fellow problem bearers.
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BARRY JOHNSON
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