The low quality bear
As last year drew to a close, we wrote extensively about the tightness of the year-end stock market rally – noting, for example, that around 40% of companies listed on the vast Nasdaq exchange were down. 50% or more of their 52-week highs. We picked up the theme again in the early weeks of this year when bad news caught up with the blue-chip S&P 500 itself. Now, however, we are looking at the other side of this trade. There was a real bear market – that is, a decline of 20% or more from the previous high – in a sizable portion of the broader US stock market. There may also be indications that this “low quality bear” may be stabilizing.
A reasonable visual of this low-quality bear can be seen in the performance of the Russell 2000 Growth Index, shown below, as well as the trend of the 10-year Treasury yield.
The Russell 2000 Growth is a small-cap index packed with technology-focused companies, many of which are at a relatively early stage in their corporate life, with unproven value propositions and uncertain future cash flow. As shown in the chart above, this index peaked in early November and began a long decline that continued during the “Santa Claus” rally of the S&P 500 and other large-cap indices in December, reaching a low. at the end of January by about 27% compared to the peak in November.
What were the immediate causes of this long decline? The inescapable story with small cap tech stocks with questionable cash flow prospects is interest rate sensitivity. Interestingly, however, the index actually leveled off and then rebounded in October when yields (the 10-year treasury represented here by the blue dotted line) rose. But the initial fall from the November peak in Russell 2000 growth followed the resumption of the upward trend in rates around the same time (this trend briefly reversed when the first news on the Covid variant omicron came out just after Thanksgiving, but since then it’s been pretty much in one direction for interest rates).
Every day has its dogs, and every dog its day
The rate impact was, of course, amplified by the already stretched valuations of many of these companies, whose stock prices had risen at a dizzying pace since the start of the post-lockdown rally in 2020. have an outsized effect on companies whose free cash flow growth patterns are more distant and more subject to change. When these future cash flows are discounted to a present value, each further rise in rates has a more negative effect on values than is the case for shorter-term stable cash flows.
At some point, however, the repricing of risk occurs and the pullback stabilizes. We may or may not be there right now, but it’s worth noting that the Russell 2000 Growth is up about 10% from that low in late January, even though interest rates have continued to increase. A forward-looking investor might argue that the market is already beginning to look beyond the current level of high inflation and commensurately high interest rates, and is heading towards the price stabilization that many expect. see it happening later this year, perhaps as early as the latter part of the second quarter.
This same investor might note that while everyone in the financial media world was obsessed this week with the inflation report showing the year-over-year increase in the consumer price index at 7.5%, which was up from the previous month’s print of 7.0%, the month-over-month gradual increase was 0.6%, the same as the month last. If this month-over-month trend were to continue in future CPI reports, it could validate these stabilization expectations.
Again, just because the Russell 2000 Growth Index has rebounded substantially from its late January low doesn’t mean we should be sounding the “clear” signal for these riskier sectors of the market. But we believe that the general theme of stabilization deserves special attention, and it is one of the elements of this theme.
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.