Investors are steering clear of small cap stocks. Here's why

The Russell 2000 Index (^RUT) has been underperforming the broader S&P 500 Index (^GSPC) year-to-date. As the prospects of an imminent interest rate cut by the Federal Reserve have diminished, investors have grown increasingly cautious about small cap companies' exposure to debt.

Yahoo Finance's Josh Schafer breaks down the details.

For more expert insight and the latest market action, click here to watch this full episode of Morning Brief.

This post was written by Angel Smith

Video transcript

- Time now to take a look at the Russell 2000. So far, down 4% this year. And more importantly, underperforming the S&P 500%-- well, the percentage gain that we've seen in the S&P 500 year to date. As of right now, you're seeing it up just shy of 5%. Many stock experts had hoped for a rebound in small cap performance. But with rate cuts remaining very uncertain, the Russell 2000, popular early year trade has disappointed.

So let's bring in Josh Schafer for more on this. Why?

JOSH SCHAFER: Yeah, Brad. So most of the strategists we were talking to back in January and December, right, a lot of people that came on this show, a very popular call was small caps are going to rally this year. It was largely based on sort of valuations. The valuation for the Russell 2000 significantly lower on a historical basis to the S&P 500. It still is, based on the performance you just showed of how the stocks have performed.

But a large part of this call really had to do with the Fed cutting rates. And I spoke with Jill Carey Hall over at Bank of America. She is the head of US Small Mid-cap Strategy over there. And they had this chart, which I think is pretty illuminating for why people are sort of backing out of the small cap trade. What you're looking at is the small caps debt exposure. You can see only 54% of small caps debt is long-term fixed.

This would mean that that debt would not be exposed to higher rates, right? We've been talking a lot about the Fed being higher for longer. Well, the left side of that pie chart, at some point if we stay higher for longer, companies are going to come back and have to borrow at these higher overnight rates. That's going to really hurt largely probably their margins. It's going to just simply cost more for them to operate.

On the flip side, when you look at the S&P 500, it's a much different story. About 80% of the S&P 500's long term debt is 80-- or sorry, is long-term fixed. You can see that on this chart here. So the S&P 500 is largely less exposed to these higher for longer rates. It sort of explains to us why we've been talking a lot about how I guess really up until this week, stocks had sort of held up even amid the higher for longer conversation. But the Russell 2000 has not.

And so it seems like still for the Russell, for small caps, for us to get really a massive broadening rally where everything kind of works, you're going to need Fed rate cuts. And they might not come this year or they might not come till later.

- But the fact that the economy, though, is holding up, right? Doing better than expected, really pointing to the fact that's part of that bull case here. So even though maybe it's taking longer potentially for this call to play out, is there still, from the conversations that you've been having, reason from strategists to be bullish here on this group but maybe the timeline is now extended just a bit?

JOSH SCHAFER: Yeah. So if we wanted to break down the small caps call into maybe three things, right, that help small caps. You just highlighted one, Sheana, that is definitely still there. It would be the economy, right? The economy doing well is normally good for small cap companies. A lot of people also think their earnings are going to pick up toward the end of the year.

Now, again, if earnings are picking up toward the end of the year, it's a little bit of a wait and see because earnings for this sector have not been great. So you sort of need to get to that part of the year, I think, to get some reassurances. And then the pitch would be, well, at that point, if we're talking about the fourth quarter when maybe earnings are picking up, maybe the economy is still growing well, maybe you get your first Fed rate cut. And then maybe that's where you start to see lift off for this index.

At this point, given the fact that we started this year with everyone talking about it, I would definitely say, wait and see and caution is what a lot of strategists are saying on this index now in this area of the market. Essentially saying, most people are saying, stay up and capsized, right? We're talking about large caps. And I think you see that a lot of days in the market action when you see the stock market get a little bit resilient, come off lows, it's large caps that are sort of getting the bid. You're not seeing a lot of days recently with the Russell outperforming the S&P 500.