Latest / Bull Market Conversations with Fexingo: Rallies, Momentum, and Riding Market Strength / Why Small Caps Are Finally Catching Up To Tech
Transcript
- Lucas: If our money conversations have helped you think about a decision differently, we want to be transparent about how we keep these shows running. A handful of listeners chip in monthly through buy me a coffee dot com slash fexingo, and that's literally what funds making this many of these without ads. Luna: Yeah, it’s just nice to know the people listening are also helping build the thing. Anyway, let’s get into today’s number: the Russell 2000 is up half a percent this week while the Dow is down six tenths. Lucas: Exactly. And that divergence is interesting because for the last eighteen months, we’ve watched the S&P 500 hit records largely driven by a handful of mega-cap technology names, leaving the broader market feeling like an afterthought. But right now, with the index at 7,723, we’re seeing a subtle rotation that suggests the bull market isn’t just about size anymore; it’s about liquidity reaching the rest of the economy. Luna: So you’re saying the tailwinds are finally hitting the smaller companies, not just the giants? Lucas: I am. Look at the Fed Funds effective rate, which is currently sitting at 3.75 percent as of early October. That stability has removed the immediate fear of a sharp repricing that has plagued small caps for years. When rates are stable but high, large companies can still borrow easily, but smaller firms usually get squeezed. Now that the market has priced in no further hikes for October, that squeeze is loosening. Luna: Right, because small caps are more sensitive to borrowing costs than Apple or Amazon. Lucas: Precisely. And when you look at the real GDP growth figure for April, which came in at 2.20 percent annualized, it wasn’t explosive, but it was enough to show that the economy isn’t contracting. For a long time, small caps needed hyper-growth to justify their valuations against cheap Treasury yields. Now, with nominal GDP hitting 32,563 billion dollars, there’s actual revenue growth happening in the mid-market sector that wasn’t there during the inflation peak. Luna: But does that revenue growth actually translate to profit margins for these smaller firms, or are they just passing savings on to customers? Lucas: That’s the key question. I’ve been looking at some recent earnings reports from industrial and regional banking sectors within the Russell 2000, and margin expansion is starting to appear. It’s not uniform, obviously, but the pressure from input costs is easing. Meanwhile, the Nasdaq is up 1.4 percent this week, showing that tech is still moving, but the gap between the two is narrowing rather than widening. Luna: So it’s not a replacement of tech, but a broadening of the rally? Lucas: Exactly. We’re seeing a broadening. Investors are realizing that if interest rates stay around this 3.88 percent daily rate level, the cost of carrying debt for smaller public companies becomes manageable. This allows them to invest in capacity and hiring, which drives that real GDP growth we just mentioned. It’s a virtuous cycle that benefits everyone, not just the FAANG stocks. Luna: It feels like the narrative is shifting from 'big tech saves the market' to 'everyone contributes.' Lucas: And that’s historically healthier for a bull market. Concentration risk is always a concern when five companies make up such a huge chunk of the S&P 500. If those five stumble, the whole index stumbles. But if the industrials, the small caps, and the services sectors are all participating, the foundation is much stronger. We saw a little bit of that with Shopifly jumping 5.1 percent this week, showing that e-commerce infrastructure is getting renewed attention beyond just the biggest players. Luna: Do you think retail investors are noticing this shift yet, or are they still chasing the big names? Lucas: It’s lagging, definitely. Most retail money is still flowing into ETFs that track the major indices heavily weighted toward technology. But institutional flows are starting to diversify. You can see it in the volume profiles for small-cap etfs like IWF, which is up 1.5 percent this week. That’s significant relative movement. Institutions are positioning for a scenario where the Fed holds steady through the end of the year, giving smaller companies four quarters of predictable borrowing costs. Luna: Four quarters of predictability is a gift in this environment. Lucas: It really is. And consider the alternative. If we had seen another rate hike in October, small caps would have sold off immediately. Instead, traders are pricing in little chance of a hike, which means the path of least resistance for these companies is upward. They can plan capital expenditures with confidence. That confidence shows up in the stock price eventually, but it starts with balance sheet management. Luna: So this is more about balance sheets than top-line sales growth right now? Lucas: Top-line is important, but balance sheet resilience is what’s driving the multiple expansion. When debt service costs drop or stabilize, net income improves even if sales stay flat. That’s leverage in the financial sense, not the speculative sense. It’s clean, operational leverage. And that’s what makes this rally sustainable rather than a speculative bubble in obscure penny stocks. Luna: Are there any sectors within small caps that are leading this charge, or is it a general phenomenon? Lucas: It’s fairly broad, but industrials and healthcare stand out. We’re seeing strong moves in companies that provide essential services and manufacturing capabilities. These aren’t flashy consumer brands; they’re the boring backbone of the economy. And in an era of 2.20 percent real GDP growth, boring is profitable. The market is rewarding stability over speculation. Luna: Stability is the new sexy in finance. Lucas: You could say that. And it’s worth noting that the VIX remains relatively calm despite the volatility in individual stocks. The overall market sentiment isn’t fearful; it’s cautiously optimistic. That optimism is spreading from the core to the periphery. The Dow might be down slightly, but that’s often noise. The underlying trend in the Russell 2000 and the Nasdaq both pointing higher suggests a unified direction. Luna: Does this mean we should expect tech to cool off so small caps can run? Lucas: Not necessarily cool off, but consolidate. Tech stocks have had a massive run. Some of that energy is rotating into value sectors. It’s not a zero-sum game where tech dies for small caps to live. It’s more like the tide rising everywhere. When the tide rises, boats that were stuck in the mud float up too. That’s what we’re seeing with the small caps. Luna: So the lesson is patience? Letting the tide do the work? Lucas: Patience and diversification. If you’re only holding tech, you’re missing out on this rotation. If you’re only holding small caps, you might miss the continued innovation premium of the big guys. The smart play is recognizing that the bull market has room for both, especially when the macro backdrop of stable rates supports everything. Luna: It’s a lot easier to hold diversified positions when the macro story is this clear. Lucas: It certainly is. And that clarity comes from watching the Fed closely. The fact that they haven’t moved rates in weeks is sending a signal that they believe the job is done. That belief anchors the entire market structure. Without that anchor, every small gain would be sold off on rumors. With it, gains become sustained trends. Luna: What happens if inflation ticks up again in November though? Lucas: That’s the risk. If CPI data comes in hotter than expected, that stability vanishes. Small caps would suffer first because their refinancing needs are closer to term. But for now, the data points to cooling pressures. Nominal GDP is growing, but real growth is moderate, which suggests we’re avoiding the stagflation trap. That’s the sweet spot. Luna: Avoiding the trap is half the battle in this market. Lucas: Always is. So as we look ahead, watch the bond yields. If the ten-year Treasury stays stable, small caps have runway. If yields spike, that runway closes quickly. But right now, the path is open. Luna: Open runway for who else besides small caps? Lucas: Regional banks and real estate investment trusts, mostly. They’re all sensitive to the same rate environment. This isn’t just a small cap story; it’s a broader credit story. The credit markets are waking up, and that lifts all boats. Luna: So it’s really about credit availability being the hidden driver here. Lucas: Spot on. Everyone talks about earnings, but credit is the lifeblood. When credit is cheap or stable, lifeblood flows to the veins that matter most for growth. That’s where we are today. Luna: Interesting perspective. Makes you look at the yield curve differently. Lucas: It does. And that’s probably the one concrete thing to take away from today: follow the credit, not just the headline earnings. The credit markets tell you who’s actually healthy before the quarterly reports do. Luna: Credit markets speaking louder than earnings calls. I’ll remember that. Lucas: Try to. Because once you start listening to the credit signals, the noise of daily stock movements starts to fade into background static. Luna: Less noise, more signal. Exactly what we need right now. Lucas: Indeed. And hopefully, that helps you navigate whatever the next quarter throws at us. Luna: Here’s hoping the next quarter keeps the rates steady and the credit flowing. Lucas: To that. Let’s see if the market agrees.