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Short small-cap stocks as that pocket of the US equity market contends with stagnate earnings growth while bonds yields march higher, Societe Generale says.
A jump in Treasury yields is in the spotlight as stubborn inflation shrinks prospects for the Federal Reserve to issue numerous interest rate cuts in 2024. The selloff in bonds last week pushed the widely watched 10-year yield (US10Y) (TBT) (TLT) to 4.7% for the first time in October, contributing to chaotic moves in stocks last week.
Small-cap stocks "are still sensitive to bond moves" even as the correlation between equities and bonds hit a peak in November especially in relation to large-cap indices, Societe Generale ((SocGen)) said in a research note late last week suggesting investors have long positions in the S&P 500 (SP500).
"Profits are once again the key reason for this. S&P 500 profits, driven by the Nasdaq-100 (NDX) (QQQ), are hitting new highs while Russell 2000 (RTY) (NYSEARCA:IWM) profits are still stuck in a range," Manish Kabra, head of US equity strategy at SocGen, said.
"Small caps are the most levered part of the market, with a large proportion of the debt on their balance sheets being at a floating rate," Kabra said.
Kabra said overall, the decorrelation between bonds and equities is "still rational" as earnings generated by large-cap companies remain strong, and their use of "shareholder friendly" actions such as dividends and buybacks does not endanger balance sheets.
Meanwhile, the US equity risk premium remains in "rational" territory at around 3.1%, just below the long-term average. The rate is low but hasn't breached the 3% threshold that would indicate an exit out of rational territory.
"The latest ERP of 3.1% and the US 10y bond yield of 4.6% are still consistent with our [S&P 500] (SPY) (IVV) (VOO) index target of 5,500. However, a US 10y bond yield of 5% would mean 8% downside for US equities," Kabra said.
Large-cap stocks this year are already outpacing the performance of small caps, with the S&P 500 up about 4.5% in 2024 while Russell 2000 has declined by nearly 4%.
See the moves across the Treasury curve on the Seeking Alpha bond page.