Why small-caps actually rally when traders price more Fed easing

Small-caps have been incredibly sensitive to the evolving outlook on whether, and by how much, the Federal Reserve is expected to cut interest rates in September.

The iShares Russell 2000 ETF outperformed meaningfully on Tuesday after an in-line CPI inflation report prompted traders to fortify bets on a rate cut and even more on Wednesday, when the prospect of a 50-basis point reduction started to seep into market pricing. On Thursday, they’re badly lagging the SPDR S&P 500 ETF after a hot PPI inflation report.

The common thinking about why the Russell 2000 outperforms as traders price more Fed cuts often goes a little something like this: the index of small-caps is more “cyclically oriented” and tied to the US economy than the large-cap stocks in the S&P 500. So the prospect of more monetary stimulus to support domestic activity gives these stocks more of a relative boost.

I would like to offer a different version of this story of particular relevance to the current situation the US economy and markets appear to be in: small-caps are incredibly speculative stocks, most of which are much more likely to end up going bust than making it into the S&P 500. These stocks have a much higher embedded probability of default than their large-cap peers. They also tend to have a much larger share of floating-rate debt than their bigger corporate counterparts, who are better able to raise funds at a fixed rate on capital markets.

Therefore, rate cuts that are viewed as sufficiently preemptive and effective at reducing the likelihood of recession, while also dropping the costs of floating-rate borrowing, put a sturdier floor under small-caps. In other words, cuts are more about mitigating potential downside in their businesses than fostering the conditions for explosive upside.

To this end, let’s look at some of the biggest companies in the Russell 2000 and how much they’ve made in sales recently:

• Credo Technology Group, the biggest stock in the index, has trailing 12-month revenues of under $500 million.

• Joby Aviation (No. 2, which recently announced the purchase of Blade Air’s passenger business): revenues of under $100,000 over the past four quarters.

• Quantum company IonQ (No. 4): $52.4 million.

• Nuclear energy firm Oklo (No. 7): Zero. Zilch. Nada.

These strike me as mostly companies with amazing potential (I mean, who knows?) in emergent industries, but also ones where near-term operational performance is highly unlikely to be driven by the near-term performance of the economy unless the economy completely falls apart.

The Russell 2000 has one major component that’s undeniably economically sensitive (regional banks), and another that is basically the opposite (speculative biotech companies).

And wouldn’t you know it, despite having similar betas to the Russell 2000 Index over the past year, the SPDR S&P Regional Banking ETF is trailing the Russell 2000 Biotech subsector by more than 1% over the past three sessions.