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Small-Cap Woes: It’s All About Rates (Not the Death Cross)

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The poor relative strength of small-cap stocks has become a popular subject on TV and the Web. Typically, smaller company stocks lead the way higher, which is why the recent weakness in the Russell 2000 index has some investors worried that the drop in the small-cap index will tip the Nasdaq and S&P 500 indexes to the loser column.

I’ve even read about the so-called “death cross,” which occurs when the Russell’s 50-day moving average falls below its 200-day moving average. This ominously sounding condition has quite a few grown-ups worried about the short-term fate of the markets in general (believe it or not), even though such an event has portended about as many tops as it has rallies.

In my view, the volatility in small caps can be attributed to interest rates. Small companies depend on variable rate loans to meet cash needs, as opposed to larger companies, which generally borrow via fixed rate bond issuance.  Investor nervousness about the direction of rates is thus being translated to reduced valuations of small cap stocks. 

This explains why the Russell dropped along with the 20+ year Treasury Bond ETF (TLT) since late August,  while the S&P 500 index traded flat to higher. 

Rates will go up eventually, but not immediately. As a result, I consider the recent weakness in small cap indices as a short-term trading opportunity.