As Sam Sees It: When Rates Rise, Look to Small-Cap Growth Stocks

Sam Stovall |

Each week, we tap the insight of Sam Stovall, Managing Director, U.S. Equity Strategist for S&P Global Market Intelligence, for his perspective on the current market.

EQ: August was a very quiet month for the market, but despite the lack of significant volatility, the S&P 500 faded into the finals days. Does this have any implications for September?

Stovall: I think investors have to remember that September is the worst month of the year by far. Not only has it posted an average negative return, just as February and August have, but it’s the only month that has fallen more than it’s risen historically. It has risen only 43% of the time since World War II, so chances are very good that we end up with a negative September.

EQ: The probability of a September rate hike seems to be inching up recently, and the market appears a bit more jittery than before. Are investors psyching themselves out or has the case for a sooner-than-expect hike strengthened?

Stovall: I think a rate hike in September is warranted, and as such, a possibility. I don’t really know why investors are freaking themselves out because the Fed has warned them for many months, if not years, that they want to push interest rates higher. Since there’s now a likelihood that it’ll happen in September, it does seem to have put investors on edge. However, I have a feeling that it will probably be more of a sell-on-rumor, buy-on-fact type of situation.

EQ: In this week’s Sector Watch, you noted that one group that could potentially benefit from the rate hike are small-cap stocks. Why are investors looking to this segment of the market if rates go up?



Stovall: Well, we’ve been hearing for the last couple of years that prognosticators are expecting for there to be this great rotation, but they kept talking about how investors would be moving out of bonds and into stocks when the Fed raises interest rates. But possibly what we’ll end up seeing is a rotation away from larger-cap, very high-yielding stocks to smaller-cap, less-yielding issues. And that’s for a variety of reasons.

First off, small-cap stocks do pay a dividend yield that is about one-third less than what the S&P 500 pays. Also higher rates will likely push up the value of the dollar, and we’ve seen over the last three years that the correlation between large-cap stocks and the dollar is 0.75 whereas the correlation between the dollar and small-cap stocks is closer to 0.55. So there would be less of an impact on small-cap stocks since fewer of them have international business.

EQ: Small-caps are known to be more volatile than their blue chip, dividend-paying brethren. If the investment thesis is reversing into this area because of macro-factors, for investors aren’t as familiar with this space, what are some good rules of thumb that they should consider?

Stovall: In my Sector Watch report, I listed a few stocks based on a screen that I did. I screened for stocks in the S&P SmallCap 600 index that have favorable recommendations by STARS (S&P analysts) and by S&P ‘s Fair Value (which is a quantitatively driven investment recommendation), and that also pay dividend yields of 1.0% or less so that they won’t get caught up in the rotation out of higher-yielding stocks.

So I would say look for stocks known for their growth potential, not necessarily for their income potential.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

Companies

Symbol Name Price Change % Volume
MTH Meritage Homes Corporation 48.05 0.10 0.21 162,001 Trade
CRUS Cirrus Logic Inc. 54.83 1.01 1.88 703,210 Trade
CACI CACI International Inc. Class A 141.45 -1.05 -0.74 72,461 Trade
BJRI BJ\'s Restaurants Inc. 31.00 1.20 4.03 538,134 Trade
ABG Asbury Automotive Group Inc 57.05 0.25 0.44 171,465 Trade
CLW Clearwater Paper Corporation 43.30 -0.70 -1.59 50,890 Trade
ITGR Integer Holdings Corporation 53.90 -0.40 -0.74 98,101 Trade

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