Small-Cap Stocks vs. Interest Rates: Exploring Correlation and Sensitivity
When discussing the relationship between small-cap and large-cap stocks in relation to interest rate changes, a common belief is that small-caps are more sensitive due to their reliance on external financing. But what does the data really reveal?
In this article, I delve into the dynamics between small- and large-cap stocks and interest rates, utilizing the Stocks, Bonds, Bills and Inflation® (SBBI®) monthly dataset and the Robert Shiller long-bond rate dataset. Through the lens of graphs, correlations, and regression, I aim to uncover the true nature of this relationship.
Key Findings:
- Small-stock monthly returns exhibit no greater sensitivity to rate changes than large-stock returns.
- Small stocks do not underperform large stocks on average during periods of Federal Reserve interest-rate tightenings.
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The correlation between stocks and rates is not static; it fluctuates over time, with periods of high rate sensitivity interspersed with periods of low sensitivity.
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The Federal Reserve Bank of Chicago’s National Financial Conditions Index demonstrates a similar relationship with small-cap and large-cap stock returns.
Stocks and Rates: An Overview
Analyzing the period from January 1926 to April 2024 using the SBBI® dataset, the correlation between small-stock monthly returns and long-government bond interest rates is explored. Surprisingly, while the correlation between large stocks and rate changes is negative, it is not statistically significant for small stocks.
Decade-wise Analysis:
Grouping the data by decade highlights potential extended periods of non-zero correlations. These correlations, usually negative, do not significantly deviate between small and large stocks, except for recent years, indicating a consistent trend across market caps.
Rolling Correlations:
By examining the rolling 60-month correlations between stock returns and rate changes, it becomes evident that small and large stocks exhibit similar responses to rate fluctuations. The charts visually align, suggesting a uniformity in behavior across different market capitalizations.
Market Effects Exclusion:
Removing large-stock returns from the equation, there’s still little evidence to support the notion that small stocks react differently to long-rate changes. The partial correlation, calculated after controlling for market influence, remains largely inconclusive.
Monetary Policy Impact:
During Federal Reserve tightening cycles, small and large stocks showcase similar performance metrics, challenging the belief that small stocks react more sharply to monetary policy changes. While historical data indicates a slight outperformance of small stocks before the 1980s, trends have since shifted.
Financial Conditions Analysis:
Contrary to the assumption that small stocks suffer disproportionately in challenging financial environments, the NFCI’s relationship with small-stock returns is comparable to that of large stocks. Deteriorating financial conditions do not seem to unfavorably impact small-cap stocks in relation to their large-cap counterparts.
In conclusion, the data doesn’t align with the widespread belief that small-cap stocks exhibit heightened sensitivity to interest-rate changes compared to large-cap stocks. By leveraging extensive datasets and thorough analysis, this article challenges conventional wisdom and opens the door to a deeper understanding of stock-market dynamics.
Remember – when it comes to navigating the intricate world of stocks and rates, a data-driven approach is key. Stay informed, stay vigilant, and let the numbers guide your path.
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