UBS: This time, small-cap stocks in the US are still facing challenges?

The Russell 2000 Index surged by as much as 12% in just five days, hitting a new high at the end of 2021. After three years, US small-cap stocks finally had a moment to shine.

Analysts at UBS, including Maxwell Grinacoff, released a research report on Thursday pointing out that the recent recovery of small-cap stocks is closely related to the Federal Reserve's policy shift and market rotation driven by the US election. The cooling of June's CPI data, enhanced market expectations for the blonde girl economy, and the restart of Trump's trades have all provided momentum for the rebound of small-cap stocks.

However, is this recovery sustainable? UBS believes that the rotation of US stocks towards small caps may continue, but only if the profit growth of large tech stocks slows down. The recent sharp decline in semiconductor stocks supports the view of rotation. The institution wrote:

Although momentum trading has started to decline, there is no evidence yet of a complete collapse in momentum trading.

Fundamentals are not optimistic

Despite the recent strong performance, UBS points out that small-cap stocks still lack strong fundamental support:

Currently, over one-third of the Russell 2000 component companies are still unprofitable.

Compared to the S&P 500 Index, the earnings forecast momentum of the Russell 2000 Index has significantly slowed down in recent quarters.

The stock risk premium of the Russell 2000 Index is close to historical lows, indicating that investors have a low assessment of its risk.

The leverage ratio of the Russell 2000 Index is high, and its ability to repay debt has declined.

Over 45% of the total debt of Russell 2000 component companies consists of floating rate notes, which may bring unexpected gains when interest rates fall, but also increase the risk when interest rates rise.

This view is generally consistent with the expectations on Wall Street. Due to the lack of substantial fundamental support, there is a certain bubble risk in small-cap stocks. Some analysts are concerned that once market sentiment reverses, it may trigger a significant pullback. keyword=%E5%B0%8F%E7%9B%98%E8%82%A1)

Several Key Observations

Looking ahead, UBS has put forward several key observations that may affect the trend of small-cap stocks:

Non-Farm Payrolls Report: The sustained moderate growth in non-farm employment in the coming months is crucial for the continued recovery of small-cap stocks.

Economic Growth: The stability of economic growth is crucial for the performance of small-cap stocks.

Inflation Reduction Process: Despite expectations, the cooling trend of CPI needs to continue.

Interest Rate Expectations: Market expectations for interest rate cuts need to remain stable to avoid concerns about "higher and longer".

Profit Tailwind Related to AI: The development of AI technology has a significant impact on the profit potential of small-cap stocks.

Investors' Capital Reallocation: Whether investors are willing to reallocate capital to small-cap stocks is crucial in determining their long-term performance.

Furthermore, small-cap stocks also face a key issue: The ability of small-cap stocks to benefit from factors such as interest rate cuts has weakened. Dennis DeBusschere of 22V Research previously stated:

The extent of interest rate cuts brought about by a soft landing has reached its maximum. The magnitude of interest rate cuts will be greater in a hard landing.

Small-cap stocks have seen the largest increase in performance in the past five days in history, indicating that they may have already absorbed all the positive news. This means that returns are likely to slow down from now on.

How to Hedge Small-Cap Stock Risks?

UBS's strategy team believes that you can obtain the potential upside of small-cap stocks by buying call options on the iShares Russell 2000 ETF (IWM) without directly purchasing these stocks.

Although call options trading is very active, IWM call options still appear relatively cheap in the current market environment.

A previous article by Wall Street News also mentioned that small-cap stocks in the current U.S. stock market are still "cheap". Bloomberg data shows that the market-to-sales ratio of small-cap stocks compared to the S&P 500 index is close to the lowest level in 20 years.

In addition, UBS also points out that the reissuance of structured financial products, especially financial notes related to the Russell 2000 index, may increase the volatility of the index and drive it further upwards