Investing should never be a popularity contest. It should be a profit contest.
To generate outsized profits, you must be willing to bet on areas not in the limelight of the media… AND do so with an evidence-rich approach.
For years, small-caps were the whipping boy of the market. Investors shunned the group as high interest rates sent capital to mega-cap tech.
This trade became so extreme, you’d be met with flying tomatoes if you made a constructive call on the down-and-out group. But that’s the exact setup you need to be aware of… when the crowd can’t imagine shifting tides.
Back in March, we laid the groundwork of why you need to buy lagging small-caps. Cheap valuations and a rate-cut tailwind made the bullish stance incredibly obvious.
Couple this with a grandiose equalizer trade set in motion earlier this month, and as they say… the rest is history.
Small-caps are now en vogue as the Federal Reserve is set to finally start cutting rates in September.
And as we’ll dive into today, that means smaller companies will soon be in uncharted territory… and beyond.
When the reward is as delicious as the data suggests, we bang the gongs here at TradeSmith to make sure you know our stance.
One historical study says keep a heavy allocation to smaller unloved equities. But before we launch into history, let’s recap the latest power thrust in small-caps.
The New Leaders
If you were in hibernation for a month and were greeted with the following market summary, odds are you’d have to pinch yourself.
Over a one-month basis:
- The Russell 2000 ETF (IWM) has gained 9.52%
- The Dow Jones Industrials Average ETF (DIA) is up 4.05%
- The S&P 500 ETF (SPY) is flat at 0.06%
- The Nasdaq 100 ETF (QQQ) has fallen 3.66%
The great news is this climate shift is very real. Don’t bet against it.
The high-rate clouds are parting… and that means new sprouts of life await smaller, less capitalized firms.
At a broad level, lower interest rates benefit small-cap, higher leveraged companies more than others. This is because when rates decline, the cost to service debt decreases… allowing profits to surge.
On the flip side, the cash-rich larger companies can be penalized in this new environment. High cash piles, routinely earning oodles of interest, will see those payments decrease as rates fall… potentially cutting into profits.
This is a big part of the sudden behavior change many investors are grappling with.
But don’t wrestle long. One of my favorite historical studies says loud and clear that you need to keep betting on this small-cap revival…
When the Fed Cuts Rates in September, Small-Caps Are Set to Fly
Earlier I told you that betting on unpopular areas is a good idea… especially when there’s data-driven precedent to do so.
Reverting back to a study we profiled in March, we pounded the table to own small-caps. History taught us that when the Fed cuts rates, and the economy isn’t in a recession and doesn’t fall into one a year later, small-caps fly.
Here’s a recap of that study. Since mid-1995, in the months after the Fed cuts rates, the S&P Small Cap 600:
- Rips 9.9% 6 months later
- Soars 19.3% 12 months later
Normally, I’d just wrap it up here… but today we’re going to take this study a step further.
Given all the recent love for the Russell 2000, I performed a similar analysis took the data back to 1991.
Not only that, but I compared the forward performance to the large cap S&P 500. Check this out.
When the Fed cuts interest rates and the economy is not in a recession and doesn’t fall into recession a year later, small-caps greatly outperform large-caps with:
- The Russell 2000 ripping 17.1% 12 months later, vs 14.2% gains for the S&P 500
- 24 months out, the Russell 2000 soars 36.6%, vs 26.8% gains for the S&P 500
If you missed the early bird calls to bet on small-caps, don’t fret. History says the current thrust has further to go.
When the Fed finally lowers rates, loosening the noose around these debt-laden firms’ necks… earnings are set to surge.
And that means their equity prices will benefit… and history agrees with today’s study validating our bullish thesis.
If your equity research only revolves around the Magnificent 7 popularity contest… you’re going to miss tomorrow’s leadership.
Remember, Profits > Popularity.
Regards,
Lucas Downey
Contributing Editor, TradeSmith Daily
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Source: Trade Smith