What is the credit market telling us about the potential of equity returns?
After significant underperformance of small cap equities relative to large cap equities during the first half of the year, we believe small cap stocks began their recovery on both an absolute basis and relative basis to large cap stocks. Although credit market improvement year-to-date has propelled the mega cap stocks, small cap stocks have been left behind. This is an unusual occurrence in a strong credit environment, and we expect small cap stocks to catch up with large cap over the next year.
The main catalyst for small cap outperformance has been the potential for the Federal Reserve (Fed) to cut interest rates after two years of raising rates and a long pause. Stronger than expected economic data in several areas such as labor, retail sales and industrial activity kept the Fed on pause longer than most expected. Excess liquidity and hype from the potential for Artificial Intelligence led to extreme outperformance from a select group of large technology companies. This has siphoned investor dollars from not only small cap companies, but also mid cap companies and most large cap companies. The large tech companies had strong numbers and have been seen as having unlimited potential that was not impaired by higher rates. With economic data slowing and normalizing, inflation data has shown a slowdown that should enable the Fed to reduce interest rates. Small cap investors, in particular, have been waiting for the Fed to act. The positioning in small cap equities relative to large cap equities has been near historic lows. With the high likelihood of lower rates, negative small cap sentiment, a supportive credit market and extremely cheap relative valuations, we believe now is the time investors will once again buy small cap stocks. We expect small cap cyclical sectors that were hit the hardest year-to-date such as consumer discretionary to significantly outperform the market while more defensive sectors underperformed.
At Penn Capital, we have always focused on the entire capital structure of companies. We believe that it is extremely important to fully understand each piece of the capital structure to make investment decisions. The way a company finances its balance sheet can determine its success and the upside or downside in its stock. Historically, the credit market has been a leading indicator for small cap returns. We follow the overall credit market to assess the strength in the economy and the opportunity in equities. As bond prices rise, the cost of capital for companies declines on the margin. This has the potential to lead to a higher present value assuming everything else is equal. Equities, particularly small cap equities, tend to perform best in periods of stable or declining credit spreads.
In the last two years, credit spreads, as measured by the Bank of America High Yield Index, declined from over 500 basis points over treasuries to below 300 basis points. The average spread in the high yield market since its inception ranges from 400-500 basis points over treasuries. Given that spreads today are below that range, the credit market is signaling a benign economic outlook. Typically, spreads reach at least 800 basis points over treasuries when a recession is looming in the near term. We do not believe that we will reach 800 basis points due to the low default rate and very strong financial characteristics of the high-yield market today. The high yield market is in the strongest financial position in history with near-record low default rates, a record high percentage of high-rated BBs, high-interest coverage and near-record low leverage. In addition, the maturity wall is low as the improving spread environment has enabled companies to refinance short term maturities at attractive prices. We believe that credit spreads should remain low as defaults are projected to be approximately 3% next year versus the historic average of 3-5%. The spread to the treasury on a high-yield bond is simply the amount
the market is willing to compensate an investor for the risk of default or impairment on their bonds.
Source: JP Morgan as of December 2024.
Overall, we believe that the credit market is signaling a better environment for small cap equities and the economy. Recessions are associated with a credit crisis, and we do not foresee a default cycle in credit for several years. Absolute valuations of small cap stocks are historically attractive with some sectors still pricing in a recession. The relative valuation of small cap stocks versus large cap stocks has stayed near historic lows. Many sentiment indicators for small cap are still very negative and there is considerable disbelief in a small cap market rally. Considering all these factors, we are very constructive on the outlook for small cap stocks.