Small Stocks Lead Gains, Defying Rising Interest Rates, As New Narratives Re-enforce The Bullish Sentiment On Wall Street

Small U.S stocks assumed the leadership on Wall Street last week even as long-term interest rates headed higher as new narratives re-enforced the bullish sentiment on Wall Street.

The small-cap heavy Russell 2000 ended the week at 2009.99, up 3.8%, beating both the S&P 500 and the Dow Jones, which gained 1.7% and 2.5%, respectively.

The solid gains in small-cap stocks came as long-term interest rates edged higher for the week. The benchmark 10-year U.S. Treasury bond ended the week with a yield of 4.19%, up from 4.15% at the beginning of the week.

That may have come as a surprise to professional traders and investors. Small caps are usually stocks of young profitless companies, trading like call options on distant future earnings. As a result, rising long-term interest rates make these earnings less valuable when discounted to the present. This means small caps should trade lower, not higher, in a rising interest rate environment.

But there are a couple of good explanations for it. First, the rally in small caps came as large caps kept on reaching one high after another. In mid-week, the S&P 500 crossed the 5,000-mark and Nasdaq is approaching the 16,000-mark. These new highs in large caps feed a new narrative on Wall Street that small caps are undervalued compared to large caps.

Second, interest rates are increasing because of a strong economy, especially a hot labor market. They are a boon to small companies, which are economically sensitive. This feeds another narrative that helped the Russell 2000 rally: the positive earnings effect of a solid economy outweighs the negative effect of rising interest rates.

"High-interest rates typically reflect a strong economy, which should coincide with higher corporate revenue and earnings," David Damiani, CFA, a chief investment officer and financial officer at Balentine, told International Business Times. "If relatively higher rates do not destroy consumer demand or compress margins due to higher debt servicing costs, stock prices can remain stable or rise in this environment," he explained.

"However, it is important to remember it is the growth in earnings that the stock market is concerned with," Damiani said, adding, "So, as we navigate through this interest rate cycle, don't simply conclude the level of rates is either positive or negative for stocks; lower rates for the wrong reasons – or an economic slowdown – could be more detrimental than higher rates with robust demand."

Marc Dizard, CFA, CFP, and Chief Investment Strategist for PNC Asset Management Group at PNC Financial Services, doesn't see new narratives behind the change in leadership on Wall Street.

"While equity markets have climbed higher along with rates remaining unchanged, I can't say this is a new narrative, Dizard told IBT. "Real Estate, Small Cap, Utilities – essentially more cyclical exposures and interest rate sensitive sectors remain challenged at the expense of the higher rate environment. The stronger overall economic data helping support the decision for the Fed to leave rates unchanged is not treating every part of the stock market the same way," he said.

Still, new narratives worry Matt Willer, the managing director of Capital Markets and a partner at Phoenix Capital Group Holdings, LLC.

"Narratives that attempt to explain market performance retroactively are often a fool's errand," Willer told IBT, adding, "Rising interest rates are a tool to curb inflation from an overheated inflationary economy that is well accepted. High-interest rates are not good for stocks because borrowing costs for nearly all issuers rise, putting a drag on the bottom line and, hence, the longer-term performance based on P/E multiples."

Willer sees the bull run of the last six months as a calculated bet among traders and investors that the U.S. economy is heading into a soft landing. It's a situation of moderate growth and tame inflation, allowing the Fed to cut rates. "So, it's a glimmer of lower rates in the future, not the higher rates of today, that are influencing part of the market's bullishness," he added.