How Could Rising Rates Affect Small-Cap Stocks?

As we continue to wait for the Fed to move on rates, questions loom as to how a rising rate environment will affect the markets. In a recent article for Proactive Advisor magazine, Validea CEO John Reese shared his thoughts on how this could specifically impact small-cap stocks.

Conventional wisdom, he explains, says that rising rates can negatively affect small-cap performance (companies with market capitalizations of between $250 million and $2 billion) since:

It leads to increased costs of the capital necessary for growth.
Small-caps tend to be more dependent on future revenue streams, and higher rates generally lead to corresponding increases in discount rates.

History shows, however, that these stocks actually perform better than large-caps during periods of rising rates (see chart below).

Reese offers the following possible explanations:

Rising rates are generally an earmark of economic growth, and smaller companies tend to exhibit strong relative returns during such periods.
It could be a function of underperformance leading up to the rate increase. When investors are waiting for the other rate shoe to drop they might avoid smaller-caps. However, once rates actually move up, they could recognize the relative value these stocks offer compared to the rest of the market.

He concludes by suggesting that contrarian investors taking a long view should consider tilting their portfolios more toward small caps to take advantage of potentially improved relative performance.