The Case for Small Caps

Brit Ryle

Posted December 15, 2023

It’s difficult to express how much of a shocker the Fed’s statement on Wednesday afternoon was. Of course nobody was expecting a rate hike. At the same time, nobody was expecting the Fed to announce interest rate cuts, either…

I expected that we’d be picking through the Fed’s choice of words about inflation and the economy like they were mystical chicken bones tossed on a dirt floor, trying to see a sign in the tangled configurations…

The Fed saved us from that mostly worthless exercise and just right out with it. Rate cuts are coming early in 2024, probably March. 

I started in this business when Alan Greenspan was Chairman of the Fed. He was as mush-mouthed as they came – if you could figure out just what the hell he was talking about, you could be gainfully employed. There were times I was convinced Greenspan would offer up utterly contradictory statements to make sure that nobody could walk away with a firm conclusion…

It was a different era. Now we like transparency…and boy did Chair Powell deliver on that.

It’s not like investors and strategist-types hadn’t been talking about the potential for rate cuts next year. They were, and that’s why stocks have rallied so much – and why I’ve been preaching that new highs are coming soon…

Powell’s rate cut promise is such a surprise, some people are suggesting that there must be some horrible economic catastrophe dead ahead, why else would the Fed be so quick to cut rates? 

I guess some people would rather poke through a pile of chicken bones than embrace the Fed’s transparency…

I prefer the zebra corollary of Occam’s Razor – when you hear hoofbeats, think horses, not zebras…

A Look at What’s Running

Banks have been huge winners the last couple of days. Bank of America (NYSE: BAC) was sitting at 52-week lows near $25 at the end of October. It powered up through its 200-day and 50-day moving averages during the November “everything rally.” Then it launched another 10% after the Fed’s statement.

You simply don’t see BofA move like that very often – it’s a good indication of how significant the Fed’s declaration is. 

And then there’s small- and mid- cap stocks…

The accepted definition of a small-cap stock is a company with a market capitalization (cap) between $300 million and $2 billion. Stocks with market caps between $2 and $10 billion are mid-caps.

These two classes of stocks did not perform well for most of 2023. But they absolutely flew during November’s “everything rally” (hence the name), and they flew again following the Fed meeting. 

I was joking around with my Pro Trader Today partner Dave Roberts, telling him that if he had any small- or mid-cap stocks that didn’t run 10% or more after the Fed, he should probably sell them. 

He owns two from the Pro Trader Today portfolio: Aehr Systems (NASDAQ: AEHR) and Rivian (NASDAQ: RIVN). 

Aehr Systems closed Tuesday at $25.24. And it closed yesterday at $29.89. That’s an 18% move. 

With a $21 billion market cap, Rivian doesn’t really count as a small company. But I’m mentioning it here anyway because it ran 23% from Tuesday to Thursday. 

Going through the rest of the Pro Trader Today portfolio:

Lovesac (NASDAQ: LOVE) ran 15.8%…

Schrodinger (NASDAQ: SDGR) jumped 13.7%… (NASDAQ: AI) moved 13%.

Now, there were a couple losers. Yeti (NASDAQ: YETI) only managed to run 8.5%. And Lemonade (NASDAQ: LMND) was even worse, only posting an 8% gain. 

Despite this egregious underperformance, I’m not inclined to bail on Lemonade or Yeti just yet (though I’ll be looking for signs of a peak for Yeti sometime after Christmas).

Year of the Small Cap?

And I’m sticking with the small stocks in the Pro Trader Today portfolio for two reasons. One, I did the work on them and I know they are quality investments, and two, because of this chart:

That’s a 5-year chart of the Russell 2000 Small Cap index (RUT). Aptly named, as you can see it was stuck in a rut for basically all of 2023. 

Even November’s rally couldn’t break the RUT out of its rut – it took the Fed to push the Russell over its 200-day moving average and signal a shift to the long-term trend. 

And I’ll tell you why this shift is significant…

2023 was dominated by Big Tech. Big Tech like Microsoft (NASDAQ: MSFT), Apple (NASDAQ: APPL) and Google (NASDAQ: GOOG) and the rest don’t really need strong economic growth to improve revenue and earnings. These companies are so ingrained in both the consumer and business worlds, they’re gonna grow, almost no matter what. Their fortress balance sheets mean they can sell bonds at lower than market rates. And investors seek them out as a safe haven.  

But now, the potential for lower interest rates can act as a wind in small caps’ sails…

Cheaper car loans can help electric vehicle (EV) sales. Lower mortgage rates can free up cash for cool furniture to put in your news house. Small companies can borrow at rates that aren’t punitive. And companies may get the opportunity to restructure current debt at better rates. 

All that’s not to say that there isn’t opportunity with Big Tech. There is…

It’s just that right now, even after a big rally, the Russell 2000 is still 30% below its all time highs. Seems like opportunity to me… 

That’s it for me this week, have a great weekend and I’ll talk to you on Monday…

Briton Ryle
Chief Investment Strategist
Pro Trader Today