Small-Cap Stocks Look Set to Outperform the Market. What to Do Now.

Just recently, Goldman Sachs’ portfolio strategists essentially assured clients in a comprehensive report that it was OK that just a few stocks were leading the stock market higher. J.P. Morgan’s strategists told clients that the stocks’ valuations were reasonable. Others are noting that the equal-weighted

S&P 500

was also at record highs, demonstrating that all stocks in the index—not just the largest ones—are doing well.

The commentary might be best viewed as the Wall Street equivalent of Sigmund Freud offering advice to neurotic rich people who need help understanding how to handle whatever is bothering them.

Rather than spending more time noting the passing scene—and reinforcing the circular nature of the analysis—let’s focus on a likely conclusion to the confusion.

If you believe that the Fed will ultimately lower interest rates later this year, as it has telegraphed, it makes sense to prepare for stocks to advance.

When interest rates are finally cut, the market mob will forget about the current maladies, real and imagined, and focus on buying stocks. The natural question thus becomes: Which stocks are most likely to benefit?

There is a nascent expectation among some sophisticated investors that small-capitalization stocks could benefit more when the Fed makes its move.

The investment thesis is simple. Smaller companies are more sensitive to interest rates than larger companies. Higher interest rates adversely impact smaller companies because they need more money to pay debt-service coverage. When rates are lowered, debt-servicing expenses will decline, benefiting small-cap earnings and stock prices.

The analysis is simplistic, as it supposes that companies will be able to renegotiate their debt with banks, which may or may not be possible. Still, this take on small-cap companies and the impact of higher interest rates is so widely held by investors that any superficial resolution of the rate question could remove a major deterrent to the sector’s performance.

The record of the small-cap

iShares Russell 2000

exchange-traded fund (ticker: IWM) compared with the S&P 500 demonstrates the potential. So far this year, IWM is up about 2%, compared with 7.6% for the S&P 500. Over the past five years, the ETF has returned about 7% a year, compared with almost 15% for large-cap stocks.

To pre-position for a small-cap catch-up trade, investors could buy IWM’s June $207 call option, which cost about $8.35 when the ETF was at $205.

Should IWM surge to $225, the call is worth $20. During the past 52 weeks, the ETF has ranged from $161.67 to $210.41.

The June expiration was selected to cover the June meeting of the central bank’s rate-setting committee. The Fed is expected to announce the first of several interest-rate cuts at the June 12 conclusion of the two-day meeting. June options expire June 21.

If the small-cap thesis is wrong, and IWM is below the strike price at expiration because the Fed doesn’t lower rates as expected, or investors decide to sell on the news, the money that was spent on the call would be lost.

Losing money is never pleasant, but Dr. Freud might observe that the experience can be more useful, at least in terms of psychological resilience and trade discipline, than a nice win.

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