To The Moon

After the Fed's 50-basis-point rate cut, investors are puzzling over which market segments will reap the greatest benefits. Lower rates offer substantial support to equities, with small-caps poised to outshine large-caps.

1.Tailwind of Falling Rates

Many investors grasp that low rates can lighten the interest burden on firms of all sizes, freeing up cash for aggressive investments in growth projects. A closer look at debt profiles reveals that, due to their debt composition, small firms may reap a bigger impact from rate cuts compared to large corporations.

Unlike large firms often saddled with fixed-rate debt, small firms face variable rates. This means as rates drop, borrowing costs plummet. Lower debt expenses translate into better cash flow, higher profitability, and superior investment opportunities. All of this fosters a fertile earnings environment for small firms.

Jefferies, leveraging data from the Fed, Haver Analytics, CRSP, and Booth School of Business, underscores that small-caps historically outperform large-caps following the initial rate cut of any cycle.

Historically, small-caps have consistently bested large-caps before, during, and after the first rate cut of any cycle, indicating robust momentum ahead.

The post-cut rally, with small-caps rising in consecutive trading days, hints at a trend reversal, signaling a shift in investor sentiment towards small-caps.

2.Small-Caps Are a Bargain

Small-caps are becoming increasingly attractive in valuation compared to large-caps. By mid-2024, the S&P 600 SmallCap Index traded at a forward P/E nearly 30% lower than the S&P 500, nearing historical lows.

Timing is crucial in investing, and sometimes, it pays to invest in relatively expensive stocks despite value elsewhere. For this reason, small-caps' cheap valuations alone shouldn't be the sole rationale. However, delving deeper into small-caps' historical performance when cheaper than large-caps suggests a decade of brilliance ahead.

3.Economic Sensitivity

Small-caps are often more sensitive to fluctuations in the US domestic economy than large-caps, which often rely heavily on international revenues. With the US economy showing signs of rebound, small-caps are well-positioned. This cyclical sensitivity means small-caps typically outgrow large-caps in earnings during economic recoveries.

4.Weaker Balance Sheets

While compelling reasons favor small-caps, acknowledging their risk nature is vital. Compared to large-caps, small firms often have weaker balance sheets, making them vulnerable to economic shocks. Furthermore, due to their sensitivity to economic shifts, small-caps tend to exhibit higher volatility.

Conclusion

The Fed's 50-basis-point rate cut last week marks the first easing of monetary policy in four years. While firms of all sizes will reap benefits, small firms stand to capitalize more. Based on the four pillars discussed, small-caps are poised to generate alpha returns over the next decade.