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(Bloomberg) — US small-cap stocks are as cheap as they’ve been in decades, but with a more than half-trillion dollar mountain of debt looming over the next five years, it’s going to take a significant risk-on signal from the Federal Reserve to entice investors.

Firms in the small-capitalization Russell 2000 Index hold a total of $832 billion in debt, 75% of which — or $620 billion — needs to be refinanced through 2029, data compiled by Bloomberg shows. For comparison, companies in the big-cap S&P 500 Index have just 50% of their obligations due by then.

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“No, despite attractive valuations, we won’t be buying yet,” said Marija Veitmane, senior multi-asset strategist at State Street Global Markets. “We don’t like small caps as they are much more sensitive to an economic slowdown, have much higher cost of funding, and margins are likely to be squeezed more.”

In particular, smaller companies tend to have a considerable amount of floating-rate debt, usually in the form of loans, because they often aren’t big enough to borrow in the bond market. That means their interest expenses often reset higher soon after the Fed hikes rates, while a bigger company with fixed-rate bond debt may wait longer before higher rates have a significant impact on their borrowing costs. 

In addition, the performance of small companies typically is tied to how the overall economy is doing. So with economic conditions in flux and uncertainty the theme in markets at the moment, Wall Street pros are skeptical of buying into the riskiest stocks — even at seemingly bargain valuations.

The Russell 2000’s price-to-sales ratio relative to the S&P 500 is near the lowest since 2003, excluding the bottoming out during the Covid pandemic in 2020. But market participants still say the index is priced for perfection and will need a strong pickup in economic growth to trigger a rally.

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“The bigger, quality names are more expensive for a reason,” said Guy Miller, chief market strategist at Zurich Insurance Co. “They tend not to have any issues around funding and are less dependent on interest rate policy.”

Lagging Performance

The Russell 2000 is up just 1.6% this year as expectations for rate cuts have dwindled to two from six in January, while the S&P 500 has gained 9.5%. But small-caps have been lagging big caps for a while, with the S&P 500 more than doubling the Russell 2000’s performance since the start of 2023. 

Indeed, the small-cap index has gone two and a half years without hitting a peak — its longest stretch since the global financial crisis, according to data compiled by Bloomberg. The S&P 500, on the other hand, has set and reset records 22 times in 2024.

The issue now for small-caps is the direction of rates and the economy as inflation remains more persistent than was expected at the start of the year. 

Stock market positioning shows a general lack of conviction in the equities rally that started at the end of April. Investors have flocked back into the so-called Magnificent Seven technology mega-caps, which are considered safer during periods of economic uncertainty, sending the Bloomberg Magnificent 7 Total Return Index up roughly 9% in the last three weeks. By contrast, hedge funds have one of their biggest net short positions in Russell 2000 futures on record, according to data from Ned Davis Research.

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Earnings aren’t helping small caps either. Russell 2000 revenues for the first quarter are on pace to rise just 0.3% versus a 4% gain for the S&P 500, figures from BI show. The rest of 2024 is likely to see an “up-and-down recovery, possibly leaving the Russell 2000 a bit volatile,” strategists Michael Casper and Gina Martin Adams said.

An analysis from Bank of America Corp. showed that even if interest rates were to stay at current levels, small-cap operating earnings outside the financial sector are likely to be reduced by 32% over the next five years, given that nearly half their debt is short term or at a floating rate.

Cash Drains

Small caps are increasingly money losers, with about 42% of the Russell 2000 currently posting negative profitability, compared with less than 20% in the mid-1990s, according to data compiled by Bloomberg.

“The quality of companies in the Russell is significantly worse than it was 20 years ago,” said Hugh Grieves, fund manager of the Premier Miton US Opportunities fund. “You’ve had a lot more companies be able to go public that have never made a profit and probably never will.”

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But Grieves also is among market forecasters who warn against dismissing all small-cap stocks. Another is David Lefkowitz, head of US equities at UBS Global Wealth Management, who sees falling interest rates by the end of the year supporting the group, and an expected pickup in business activity translating into stronger earnings.

“It’s not that small caps are bad,” said Lefkowitz, who turned overweight on the group in December. “It’s just that on a relative basis, large is doing better.” 

BofA strategist Jill Carey Hall is telling clients it makes “sense to be selective” as pockets within the energy, materials and industrials sectors are attractive given their sensitivity to an improving economy and relatively lower refinancing risks. But investors are proving a tough sell.

“The sense we get is that they’re waiting for more confidence in inflation slowing and that the Fed will be able to start cutting,” she said.

And for Premier Miton’s Grieves, it really isn’t about small caps anyway. It’s about the lack of reasons to shun the tech behemoths that have been winners the whole time.

“What it keeps coming back to is the Magnificent Seven,” he said. “Once they stop outperforming, then you will see fund managers start to get more excited about small caps.”

—With assistance from Sujata Rao, Jan-Patrick Barnert, Elena Popina and Jessica Menton.

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