US Small-Cap and Micro-Cap Stocks Prepare for Counterattack on Interest Rate Cut Cycle...End of Big Tech's Solo Run?

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A diagnosis has emerged that small-cap and micro-cap stocks, which had been marginalized in a market dominated by large technology stocks, have seized a genuine opportunity for a rebound with the advent of an interest rate cut cycle.

According to the US financial media outlet Barron's on September 28 (local time), market experts analyzed that the valuation appeal of small-cap and micro-cap stocks is being highlighted, coinciding with the Federal Reserve's (Fed) accommodative monetary policy stance. For years, big tech companies, dubbed the "Magnificent Seven," have monopolized market gains, leading to the widest gap in price-to-earnings ratios (PER) between mega-cap and small-cap stocks in decades.

The easing of borrowing cost burdens has been identified as a key trigger for improving small-cap stock performance. Small-cap companies, compared to to large corporations, have a higher proportion of variable-rate debt, leading to severe margin pressure due to interest burdens in a high-interest rate environment. As the Fed enters an interest rate cut cycle, interest expenses are expected to decrease and liquidity conditions improve, leading to observations that the net profit growth rate of small and medium-sized listed companies, including those in the Russell 2000 index, could surpass that of large-cap stocks.

Historical data also supports the high returns of small-cap stocks during periods of monetary easing. In numerous past instances, small-cap stocks have achieved outperformance compared to large-cap stocks during the 12 months following the start of the Fed's interest rate cut cycle. In particular, fundamentally sound micro-cap stocks, which have extremely small market capitalization and have been outside the interest of institutional investors, remain severely undervalued, and are expected to see a sharp price recovery upon the inflow of capital rotation.

However, the advice followed that selective screening, meticulously considering debt ratios and free cash flow, is essential rather than an indiscriminate approach. Given that the proportion of loss-making companies within the small-cap index has increased compared to the past, an analysis suggests that a portfolio structured around financially sound companies that can fully absorb the benefits of falling interest rates will determine returns.

[Article Key Summary]

-The valuation gap between large-cap and small-cap stocks has widened to its largest in decades due to the dominance of big tech.

-With the onset of the Fed's interest rate cut cycle, the interest burden on small-cap stocks, which have a high proportion of variable-rate debt, is rapidly decreasing.

-Historically, small-cap stocks have outperformed during interest rate cut phases, thus requiring the selection of undervalued stocks with strong fundamentals.

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