Smaller Fed Cut May Bring Small Cap Reversion, RBC’s Calvasina Says

Summary

In the discussion, Jon and Laurie delve into the vulnerability of small-cap stocks in the wake of potential Federal Reserve interest rate cuts. With the market anticipating a 50 basis point cut, small caps surged, but Laurie warns that if the Fed only delivers a 25 basis point cut, there could be a reversion. She notes that small caps are currently fully valued and positioned, contrasting with their under-owned and cheap status a few months prior. Laurie emphasizes the need for a strong economy with above-average GDP growth, suggesting that a soft landing with only 1.5% to 2% GDP growth won't suffice for small caps; they need a more robust 2.5% to 3% or better.

Takeaways

• 🏦 The discussion revolves around the potential impact of a 25 basis point interest rate cut by the Federal Reserve on small cap stocks.
• 📈 Small cap stocks surged on optimism about a 50 basis point cut, but there's concern about their vulnerability if only a 25 basis point cut occurs.
• 📊 Current valuations for small caps are considered full, and market positioning is also full, unlike a few months ago when they were undervalued and underowned.
• 📉 There's a worry that if the Fed cuts by only 25 basis points, there could be a reversion in small cap stocks, as they were propelled by fast money crowd and passive flows, which can be fickle.
• 💼 The economic data and the state of the economy play a crucial role in the performance of small caps, with the need for a delicate balance between growth and stability.
• 📉 Small caps typically perform well during cutting cycles, but a recession could change the investment strategy to selling into the recession and buying on the way out.
• 🚀 For sustained outperformance, small caps need an economy that's not just growing, but growing above average, with GDP growth of 2.5% to 3% or better.
• 🔍 The conversation highlights the importance of economic indicators and how they can influence investor sentiment and market behavior, especially for small cap stocks.
• 💭 There's a nuanced view on the Fed's actions and the economic backdrop, suggesting that the market's reaction to Fed decisions is complex and multifaceted.
• 🌐 The discussion implies that global economic conditions and the Fed's policy decisions are closely watched by investors, especially in the context of small cap stocks.

Q & A

What is the significance of the number 25 mentioned in the transcript?

The number 25 refers to a 25 basis point interest rate cut by the Federal Reserve, which is a topic of discussion regarding its impact on the market, particularly small cap stocks.

Why did small cap stocks surge on Friday as mentioned in the conversation?

The surge in small cap stocks was attributed to renewed optimism about a 50 basis point cut by the Federal Reserve, which was anticipated to be positive for these stocks.

What does the term 'valuations are full' imply in the context of small cap stocks?

When the speaker says 'valuations are full,' they mean that the current price of small cap stocks reflects all known information and may not be undervalued or under-owned as they were a few months ago.

What is the concern expressed about small cap stocks if the Fed only cuts by 25 basis points?

The concern is that if the Fed cuts by only 25 basis points instead of the 50 that propelled small caps higher, there could be a reversion or a drop in the performance of small cap stocks.

Who is driving the recent trade in small cap stocks according to the discussion?

The recent trade in small cap stocks is being driven by the 'fast money crowd,' indicating that the investments are more speculative and potentially short-term in nature.

How does the type of economic growth impact small cap stocks according to the transcript?

Small cap stocks need a strong economy with above-average GDP growth to perform well. A soft landing with low GDP growth may not be sufficient for small caps to continue their outperformance.

What historical pattern is mentioned regarding small cap performance during a cutting cycle?

In past cutting cycles, small caps have done very well and started a longer-term outperformance cycle. However, if a recession occurs, the strategy shifts to selling before and buying after the recession.

What is meant by 'threading the needle' in the context of small cap stocks?

The phrase 'threading the needle' refers to the delicate balance required for small cap stocks to continue performing well. It means avoiding a recession while still achieving strong economic growth.

What percentage of GDP growth is suggested as necessary for small cap stocks to thrive?

For small cap stocks to really thrive, the GDP growth needs to be around 2.5% to 3% or better, as mentioned in the transcript.

What is the implication of passive money flows into small cap stocks as discussed?

Passive money flows into small cap stocks are described as 'very, very fickle,' suggesting that they can be unstable and may lead to sudden shifts in the market.

Outlines

00:00

📈 Small Caps Market Concerns Post-Fed Decision

The discussion revolves around the potential vulnerability of small-cap stocks following a Federal Reserve decision. The speaker, Jon, expresses concern that if the Fed only cuts rates by 25 basis points instead of the expected 50, there could be a negative impact on small caps that had recently surged due to optimism about a more substantial cut. The conversation highlights that small caps are no longer undervalued or underowned as they were a few months ago. The current optimism is seen as being 'baked in,' and there is a worry that passive investment flows, which have been driving the small-cap market recently, could be volatile. Laurie adds that small caps typically perform well in cutting cycles but cautions that they require a delicate balance of economic conditions to continue this performance. A recession could see small caps underperform, while a soft landing with moderate GDP growth might not be sufficient to support them.

Keywords

💡Small Caps

Small caps refer to stocks of companies with a relatively small market capitalization. In the context of the video, they are discussed as a potential investment area that has recently seen a surge due to optimism about interest rate cuts by the Federal Reserve. The speaker suggests that while small caps have advantages, they are currently fully valued and may be vulnerable to changes in market sentiment, as seen in their reaction to the anticipation of a 50 basis point rate cut.

💡Valuations

Valuations in finance refer to the process of determining the current value of an asset or company. In the video, the term is used to discuss the perceived 'full' valuations of small cap stocks, meaning they are currently priced at a level that reflects all available information and may not offer significant buying opportunities at present.

💡Positioning

Positioning in investment terms refers to the act of adjusting one's portfolio to take advantage of expected market conditions. The speaker mentions that the positioning in small caps is also 'full,' indicating that many investors are heavily invested in this sector, which could lead to a rapid change in sentiment if market conditions shift.

💡Fed Optimism

Fed Optimism refers to the positive sentiment in the market due to expectations of favorable actions by the Federal Reserve, such as interest rate cuts. The video discusses how this optimism has influenced the performance of small caps, suggesting that the market has already priced in expectations of a rate cut, which could lead to a reversion if the anticipated cut is not as significant as hoped.

💡50 Basis Point Cut

A 'basis point' is a unit of measure used in finance equal to 0.01%. A '50 basis point cut' refers to a reduction of 0.5% in interest rates. In the video, the discussion revolves around the market's anticipation of such a cut by the Federal Reserve, which has driven the performance of small cap stocks. The speaker expresses concern that if the cut is only 25 basis points instead, there could be a negative impact on small caps.

💡Passive Money

Passive money in investment refers to funds that are invested in a portfolio with the intention of tracking a market index, rather than being actively managed. The speaker points out that recent flows into small caps have been driven by passive investments, which can be volatile and may quickly shift out of a sector if market conditions change, potentially leading to instability in small cap valuations.

💡Economic Data

Economic data encompasses a wide range of statistics that reflect the economic health of a country or region. In the video, the speaker emphasizes the importance of strong economic data to support the continued outperformance of small caps. Without robust economic indicators, the positive trend in small caps may not be sustainable.

💡Recession

A recession is a significant decline in economic activity that lasts more than a few months, typically visible in real income, employment, and production. The video discusses the historical performance of small caps during recessions, suggesting that they tend to underperform going into a recession but can offer opportunities for investors looking to buy on the way out.

💡Soft Landing

A soft landing in economics refers to a period of slower economic growth that avoids a recession. The term is used in the video to describe a scenario where the economy grows at a moderate pace, such as 1.5% to 2% GDP growth. The speaker argues that this level of growth may not be sufficient to support the continued strong performance of small caps, which may require a more robust growth rate of 2.5% to 3% or better.

💡GDP Growth

GDP (Gross Domestic Product) growth measures the rate at which a country's economy is expanding. In the context of the video, the speaker suggests that small caps require above-average GDP growth to thrive. This implies that without strong economic expansion, the performance of small cap stocks could falter.

Highlights

Discussion on the potential impact of a 25 basis point rate cut on small caps.

Small caps surged due to renewed optimism about a 50 basis point cut.

Valuations for small caps are currently full, and they are not undervalued as they were a few months ago.

Positioning in small caps is full, indicating a crowded trade.

Concerns about a potential reversion in small caps if a 25 basis point cut is announced instead of 50.

The role of fast money crowd in driving the small cap trade.

Recent flows into small caps have been passive, indicating potential volatility.

The importance of economic data in sustaining the small cap rally.

The historical performance of small caps during cutting cycles.

The strategy of selling small caps on the way into a recession and buying on the way out.

The need for an above-average GDP growth for small caps to continue outperforming.

The concept of a soft landing and its implications for small cap performance.

The required GDP growth rate for small caps to thrive, suggested to be 2.5% to 3% or better.

Transcripts

Lori, I know the house for you is 25, and I just wonder if we get that 25.

And of course, welcome to the program, by the way.

If we do get that 25, how vulnerable certain traits like the small caps

actually are. Hi, Jon.

So thanks for having me. Look, I think it's a great question.

And we were watching the Smallcaps just surge on Friday as the renewed optimism

about the 50 basis point cut came came up as well.

And look, I think small caps have a lot going for them.

But the reality is that valuations are full and positioning is also full.

If you go back a few months ago, they looked under owned, they look cheap.

We're just not there anymore. And now we've got a lot of Fed optimism

baked in. So I do think in the short term, at

least, if we're just thinking about the week ahead, I do worry a bit that if we

get the 25 rather than the 50 which propelled Smallcaps to these great

heights on Friday, that there could be a bit of a reversion in the small caps.

I think that, you know, we really have sort of more of the fast money crowd

sort of driving that trade right now. If you look at recent flows into small

cap, they have been all passive driven and that passive money does tend to be

very, very fickle. You have a nuanced view here, Laurie,

with respect to not only how much the Fed cuts, but also the economic data

behind it. That needs to keep this going.

There was this feeling that the Fed was on track to cut by 50 basis points

without real pain visible in the US economy.

How much is any kind of weakening, even if not a recession, sort of a bear case

right now for small caps? So I think the small caps really need

the needle to be threaded. And what I mean by that is if you go

back and look at past cutting cycle, small caps do really, really well and

embark on a longer term outperformance cycle.

If you get a recession, if you break the economy, it's small cap 1 to 1 to say

you sell them on the way into a recession, you buy them on the way out,

and you tend to see that pivot midway through.

But if we don't get that and we get some sort of economy that's still growing, I

do think it depends on what kind of growth we get.

And if you look at the other side of the equation, we really do need a hard

economy above average GDP for small caps to really keep going.

If you look at recent trading data since, say, 2015, 2016.

And if we're just kind of I guess I think it comes down.

Lisa, what do you mean by soft landing? A soft landing that's looking at like

one and a half percent type GDP growth, maybe even two?

I don't think that quite cuts it for small cap.

I think you need something more like two and a half to 3% or better.