In our last weekly blog we predicted that the December Fed meeting would be a positive catalyst to push the stock market higher as the cycles have been positioned to go higher.  The Fed Chair Powell shocked everyone in the December meeting hinting that interest rate cuts could be happening in 2024 as inflation has come down meaningfully.  The market took it further to speculate that the first rate cut could happen as soon as March 2024.  Because of the optimism with the perceived imminent rate cuts, the stock market rallied.  The small caps rallied 5.48%, S&P 500 rallied 2.49% and the NASDAQ rallied 2.84% last week.

It’s rare for small caps to outperform the general market as small caps are more cyclical and more susceptible to deteriorate macro conditions.  Small caps are extremely sensitive to higher interest rates.  An important thing to note is the most widely used index for small-cap stocks, the Russell 2000, currently has over 42% of its constituents earning no profits. That percentage is well above the long-term average and could go higher if the economy enters into recession.  That’s why during the rate hiking cycle March 2022 – July 2023, no one wanted to own small caps and the valuation gap between the large cap and small cap is at historic level.

There have been a few times during the 2022 bear market that small caps outperformed the large caps.  People have been reading the small caps out-performance tea leaves to indicating a new bull market.  The sustained small caps out-performance is a very reliable reading of the beginning of a new bull market.  Before we draw the conclusion of the current small caps rally, let’s look at the small caps long term chart in relations to the Fed interest rate decisions

Below is the small caps ETF IWM long term monthly chart.  In this chart we noted the important turning points in relationship to the past Fed interest rate decisions.

Important points from this long term monthly chart.

  1.  Small caps bottomed with the general market in March 2009 when the Fed Funds rate was at 0%.
  2. The Fed kept the interest rate at zero to heal the housing crash until December 2015
  3. The small caps investors figured out interest hiking was coming 6 months in advance of the actual rate hike by making a top in June 2015, the S&P 500 topped in December 2015 right up to the Fed rate hiking decision.
  4. The February 2016 shallow bottom was made together with the general market
  5. The small caps investors figured out something is wrong with the macro by making a top in August 2018, one month before the S&P 500
  6. The Fed paused interest rate from December 2018 to August 2019.  Between the pause and rate cuts, the S&P 500 was able to make a new high in February 2020 while the small caps topped out in January 202o with a lower high than August 2018.  This divergence between the small caps and S&P 500 shows how difficult it has been for the small caps to function in the higher interest rate operating environment.
  7. The Fed reacted aggressively to Covid-19 and the entire market made a bottom in March 2020 and the interest rate went back down to zero in March 2020.
  8. December 2008 was the last interest rate cut from the previous Fed cycle and March 2020 was the last interest cut from the past Fed cycle.  It took more than 12 years to finish one Fed rate cycle trough to trough.

Now in the present Fed rate cycle, the starting point is in March 2020, the lowest interest rate location.  The peak interest rate location is in July 2023 as the Fed talked about rate cut in the December 2023 meeting.  The Fed’s talk of rate cut in December 2023 meeting essentially confirmed that the peak rate is 5.25-5.50% which was set in July 2023, 5 months ago.

This clearly shows that we are currently living in the middle of the Fed rate cycle.  We have an interest rate trough (March 2020) and a peak (July 2023), now we are waiting an interest rate trough to finish the Fed rate cycle.

The small caps started rally in November 2023, 4 months after the last rate hike in July 2023.  This small caps rally clearly is a mid Fed rate cycle rally, not indicating the beginning of a new bull market.  It is rallying against a more challenging higher interest rates operating environment.  This is truly a bear market relief rally for the small caps.

Historically, there is a 10% rally from the last rate hike to the first rate cut.  The last rate hike was on July 23, 2023 when the S&P 500 was at 4566.  10% over 4566 is  5022.  So if history repeats itself, no can expect the S&P 500 to rise another 6.5% to 5022 whenever the first rate cut occurs.  This 10% post rate hike rally will help the S&P 500 to make a new all time high before an interest rate trough is made.

So the answers to the current state of the small caps rally are:

  1.  The small caps are in the mid Fed rate cycle rally against a more challenging higher interest rate operating environment.  It will not exceed its old November 2021 high, but the S&P 500 will exceed its all time high to break out to exceed 5000 level.
  2. The small caps are only two months into the mid Fed rate cycle rally.  It will have some time left in the bear market rally.
  3. The current small caps out-performance will not long last as the S&P 500 is more durable in the higher interest rate operating environment.

The year-end rally will go on and the first dip in 2024 should be bought.

We will not blog next Sunday during the Christmas weekend.  But we will resume during the New Year’s weekend.

Happy Holidays Everyone!