Best US Stock Investment for 2024

Best US Stock Investment for 2024

Exploring the Impact of Federal Reserve Rate Cuts: A Look at Loan Company Stock Price Volatility

The most significant impact of the Federal Reserve’s rate cut policy is undoubtedly on lending institutions.

Taking companies such as Affirm, Square, Rocket Companies, and LendingClub as examples, their stock prices have been influenced by multiple positive factors. On the day the rate cut was announced, the market reaction was very dramatic. Affirm’s stock price climbed a hefty 12%, and Upstart saw a short squeeze situation, with a substantial gain of 20%. There are mainly three reasons for this situation:

Lower Loan Costs and Increased Market Demand

First is the reduction in borrowing costs. Rate cuts usually mean that the interest rates for commercial loans could decrease, potentially allowing these companies to acquire capital at lower costs, thereby enhancing their liquidity, aiding in business expansion, or providing more competitive rates to borrowers.

Second is the stimulation of loan demand. Low interest rates are likely to encourage consumers and businesses to take out loans. If interest rates decrease, the demand for loans may correspondingly increase, which for companies like Upstart, could mean an influx of borrowers seeking their loan services.

The third point is the heightened market demand. Rate cuts may stimulate overall economic activity, raising the levels of consumption and investment, which in turn would lead to more people seeking loans, further boosting the market demand for companies like Upstart.

Prospects for Financial Lending Enterprises

Overall, the Federal Reserve’s rate cut policy may have provided financial lending enterprises with lower funding costs and greater market demand, which will help drive their business growth and increase market share. However, the realization of this impact also depends on macroeconomic factors and the state of corporate internal management.

In addition to the direct impact on lending companies, over the past month, the small-cap index Russell 2000 outperformed S&P 500 and the large-cap index Russell 1000 with its strong performance. Behind this trend are two key factors: its notable valuation appeal and excellent risk diversification. This makes us wonder whether Russell 2000 might become the stock investment category to watch in 2024.

Russell 2000: An In-Depth Analysis of Small-Cap Stocks

In this article, we delve into the stellar performance of the Russell 2000, offering a comprehensive analysis and discussing potential risk factors.

Indicator of Importance for Small-Cap Stocks: Russell 2000

Data shows that the Russell 2000 index representing small-cap stocks rose over 10%, outperforming the S&P 500’s 5.26% and the Russell 1000 index representing large-cap stocks’ 5.7% gain. Particularly on October 31st, an in-depth technical analysis revealed a bottom signal in IWM (the Russell 2000 index fund), although it was not very distinct. However, on November 1st, there was a significant shift in the storyline. While researching on stock analytics website stock-dot-com, we noticed a sharp rise in the put option premiums for IWM peaking at a staggering $1.7 billion on October 4th, whereas the call option premiums were negligible. The drastic change on November 1st saw a 50% drop in the trading volume of put options, suggesting a major upcoming shift in the market. Indeed, since then, IWM began to climb rapidly, as if long-standing pressures were released.

Among the nearly 3000 companies that make up the entire US stock market, the top third in terms of value form the Russell 1000 index, while the remaining 2000 companies make up the Russell 2000 index. The latter is seen as a focal point for observing small-cap stocks, hence clarifying whether small caps are headed for a rejuvenation.

Analyzing Small-Cap Stocks from a Historical Returns Perspective

Firstly, let’s analyze from the pattern of historical returns. Historically, small-cap stocks tend to have above-average excess returns, which is related to their higher growth rates and earnings acceleration. In the US, small-caps represented by the Russell 2000 have historically outperformed large-caps denoted by the S&P 500. According to MSCI data, since December 1998, small caps have performed better than large caps in both developed and emerging economies, with an MSCI World Small Cap Index’s annualized excess return rate of 2.69%. Considering the recent challenges faced by small caps, we look forward to evaluating their performance relative to larger companies over a longer time horizon. Through rolling window analysis, we found that as the holding period increases, the win rate for smaller companies in both developed and emerging markets gradually improves. Historical data shows that in a 15-year investment cycle, small caps have about a 90% chance 14 times to outperform large caps, as indicated by respective MSCI indexes.

Although small caps have underperformed in the past five years, as of the end of November, the Russell 2000 index’s five-year annualized return rate was only 4.8%, while that of large-cap stocks was significantly higher. However, this may also mean that small caps’ relative performance against larger companies has reached an extreme level, priming for an upcoming rebound.

Historical return data for small-cap stocks show that, following periods of below-average returns, periods of above-average returns often follow. Of all 86 five-year periods in the Russell 2000 index, whenever the annualized return rate was below half of the average, the subsequent three-year annualized return rate was usually positive, with an average of a robust 17.5%. The historical pattern suggests that the current low-return period may lay the foundation for an upcoming period of active performance for small caps.

With global stock markets rebounding as the rate hike cycle ends, investors holding undervalued small-cap stocks have the potential to outperform large caps. Historically, following the last Fed rate hike, the Russell 2000 index’s annual average gain reached an impressive 18.4%.

Valuation and Fundamental Analysis

Next, let’s look at valuation and fundamentals, which will help us assess the allure of small caps. The historical excess returns of small caps have been underpinned by the size premium. We measure valuation using the MSCI World Small Cap Index’s forward price-earnings ratio (PE) over 12 months and assess profitability using the index’s return on equity (ROE). As of May 2023, compared to the past 15 years, the valuation of small caps is at a historical low, while profitability is near a historical high. This means that small caps are currently relatively cheap, while the profitability status of companies is relatively good.

Profitability is another key fundamental factor. Since June 2021, the historic earnings per share (EPS) growth trend for small caps has been on the rise. Analysts’ EPS forecasts for small caps have begun to improve since early 2023, following a steady decline since 2021. Over the past decade, liquidity for small caps has increased, which is a positive sign since historically many small-cap stocks’ low liquidity has added challenges to asset allocation into small caps. Our analysis indicates that over the past ten years, small-cap liquidity has significantly improved, likely due to the increase in the overall index market capitalization size. From the overall index perspective, the average annual trading value ratio for small companies is typically higher than that for larger companies.

Diversification and the Potential of Small Caps

Lastly, let’s discuss how small caps can be viewed from a risk diversification perspective. In recent years, the long-term performance of small caps has lagged behind the overall market, and this has to do with the market value concentration of several leading companies in the S&P 500 index, such as NVIDIA’s proportion in the S&P 500 reaching a new high of almost 30%. This year, the S&P 500 index is expected to gain only 8%, rather than the previously projected 20%. This means that those invested in the S&P 500 index have nearly a third of their funds in these expensively priced stocks, when a pullback occurs, the index will face a substantial risk of decline, which does not align with the principle of diversified investment. For this reason, small caps become an important tool for diversifying the concentration risk of large-cap stocks. In the 2000 dot-com bubble, small caps outperformed large-cap stocks and maintained this dominance for a substantial period. Furthermore, despite small caps’ higher sensitivity to the macroeconomy, this also indicates they are more prepared for a recession. If the economy does fall into a recession, small caps may perform better. Historical data indicates that during significant events including the global financial crisis, small caps generally outperform large stocks. For example, during the financial crisis, small caps exceeded by 12.4%.

Although the market is optimistic that the US economy will have a soft landing next year, for investors holding the opposite view, small caps with better prospects in a severe recession are attractive. And over a longer period, we see that most scenarios show a positive trend. For instance, 18 months after the first Fed rate hike in March 2022, the Russell 2000 index fell by 10%, while the Russell 1000 index saw a slight increase. Yet, historical data indicates that returns tend to be positive in the one and three years following the Fed’s first rate hike. The recent deviation from historical patterns, for us, suggests that the market may have potentially priced in a recession, and a higher return for small caps could be on the horizon.

Another historically subtle pattern that has yet to be apparent is the link between small-cap performance and high-yield credit spreads. Typically, when credit spreads contract, small-cap stock prices usually rise. In the past 14 months, high-yield spreads have dropped by about 200 basis points, yet during this period, the Russell 2000 index fell by 3.5%. In contrast, the last time high-yield spreads dropped from similar levels, the Russell 2000 index surged by 34.1% in just five months. Though these historical patterns are interesting, we are more stimulated by the combination of valuations and long-term opportunities.

Where’s the risk?

Currently, the Russell 2000 is valued low, but this didn’t come out of nowhere. Firstly, small caps typically come with higher volatility. The past five years’ annualized volatility reached 24.6%, much higher than the 19.5% for the Russell 1000 index. Secondly, among the companies in the Russell 2000 index, a substantial number are unprofitable. According to a report by Apollo Global Management released in mid-November, about 40% of the constituent companies of the Russell 2000 index are in a loss-making situation—even in the context of robust economic growth in the US. If the American economy does enter a recession, this proportion may rise further, as they would be hit by both high-interest rates and economic slowdown. The rise in the proportion of unprofitable companies is unsurprising, but even during good economic conditions, the high proportion of unprofitable companies in the Russell 2000 is indeed something that industry experts and investors need to ponder over.

The valuations of small caps we previously mentioned were calculated excluding loss-making companies. Including these loss-making companies in the calculation could reduce the overall profitability of the denominator, thus raising the valuation of the overall index PE. As of the end of November, the Russell 2000’s forward PE ratio is a hefty 21.7 times, quite high.

From a balance sheet perspective, small caps face less fixed-interest risk, but are more susceptible to funding pressures. According to Goldman Sachs, there are two key differences in financing between small and large companies. Small firms see a higher proportion of their output in interest payments, reflecting their higher debt pricing and the rising proportion of debt to production value. For example, in 2019, the effective interest rate for small and medium enterprise loans was about 10.5%, while the corporate sector was at 6.5%. Furthermore, although the debt maturity profile of small and large firms appears similar, about half of the debt for small firms comes from credit lines, short-term loans, and other variable-rate debts, while only 20% of large firms have such proportions.

Thus analyzed, even if small caps have recently shown strong performance and seem cheap, the full impact of the rate hike has yet to be fully revealed. Looking at historical data, after a rapid rise in small caps, the subsequent upward momentum often weakens. We need to remain vigilant with these historical trends, especially when planning long-term investment strategies.

And that concludes today’s sharing. Thank you for reading. If you agree with our views, remember to bookmark this column and share with friends. We will continue to bring more exciting investment analyses in our next issue, so stay tuned.