Rising Rates and Small-Caps

12/29/2014 8:00 am EST

Focus: STOCKS

James Oberweis

President, Oberweis Asset Management, Inc.

Over the longer-term, we expect that interest rates are going up everywhere, with the US increasing rates first and the rest eventually following suit, forecasts Jim Oberweis, Jr., editor The Oberweis Report.

At first blush, one could easily conclude that rising rates will be a headwind for growth-oriented small-cap investors.

Theoretically, if the market ultimately values equities based on discounted future cash flows, a higher discount rate would seem to imply that small-cap valuations should be more sensitive to rising rates.

Small-caps are often valued on their long-term earnings growth, but rising rates mean the present value of a dollar earned five years out will mathematically be worth less.

Thus, all else equal, theory says that small-caps should underperform in a rising rate environment.

However, the empirical results paint a different picture. Rising interest rates have not correlated with small-cap underperformance in the last few decades.

Using the S&P 500 as a proxy for large-cap stocks and the Russell 2000 for small-cap stocks, actual results show that small-cap stocks delivered above-average absolute returns and performed better relative to large-cap stocks in rising rate environments.

Admittedly, the relationship isn’t linear; the best periods for small-caps occurred in certain periods when rates fell substantially, such as 1981-1983 and 1984-1986.

In short, rising rates do not appear to negatively correlate with small-cap stock returns and indeed appear to have modest positive correlation.

How could this be? One possible reason is that interest rates tend to rise in response to a stronger economy. And a stronger economy is very good for small-caps.

As you would expect, there appears to be a high correlation between small-cap returns and acceleration in the rate of GDP growth. When the economy starts humming, small-caps usually start to fly.

That’s usually about the time the Fed puts the brakes on growth with higher rates, but the adverse effect of higher rates is usually smaller than the positive effect of an accelerating economy.

Given that small-cap valuations are already attractive compared to large-cap stocks, expect an accelerating economy to lead small-cap stocks to outperform in 2015, even if interest rates start to tick up.

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