Broker Check

UFG Market Perspective

| October 09, 2023

The bull market that began almost one year ago has been very unusual.  One of the notable aspects is the performance of small-cap stocks.  Per Lowry Research, through September 30, 2023:

Of the 10 new bull markets since its inception, this would be the weakest 1-year return for the Russell 2000 Index off the bottom (+7.2%) vs. an average of +53% and a best of +118%.  This is especially noteworthy since small-caps historically perform best in new bull markets vs. the other major price indexes.

Below is a graph of the performance of small-cap stocks, represented by the Russell 2000, and large-cap stocks, represented by the S&P 500, since the prior market high in January 2022 through this week.

Source: Morningstar Direct

One big question is why this bull market is so unusual.  One possible reason is that small-cap stocks already feel the pain of higher interest rates.  As I mentioned in my last letter, the effect of higher interest rates has not spread evenly.

Below is a graph displaying the effective interest rates that different tiers of the market pay.  We can use the S&P 500 as a proxy for the red line and the Russell 2000 for the blue line. 

Source: Soc Gen/The Market Ear

As you can see, the largest 10% (red line) of companies are paying a much lower rate than the smallest 40% (blue line) of the stock market.  The top 10% are paying the lowest interest rate in a decade, whereas the bottom 40% are paying the highest.  Investors are reacting rationally to the current environment.  The stock of companies already feeling the pain of higher rates have not appreciated as much as those that have not.

Earlier this year, investors expected that the Fed would begin to cut rates possibility this quarter.  Those expectations reset recently, and the chance that interest rates are higher for much longer continues to weigh on investor allocation decisions.

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