One of the overarching themes that has dominated the marketplace for the past several years is a relentless focus by investors on quality, cash-flow-yielding stocks. Why? Because companies burdened with high debt and low profit margins may not be able to survive rolling over their debt into higher rates. These so-called zombie companies, of which many exist in the small-cap space, are walking dead for a reason. These stocks have been an anchor, preventing broader small-cap indices from making 2021 highs.
Meanwhile, small-cap stocks that have high free cash flow? They’ve done just fine. ETFs like the Pacer US Small Cap Cash Cows 100 ETF (BATS:CALF) clearly prove this. This ETF is in a bull market, having taken out 2021 highs. The Russell 2000? Not so much.
So, the question becomes what happens if we compare that fund, as a proxy for cash-flow demand, to the passive Russell 2000, which has a significant amount of these walking-dead companies?
The price ratio of CALF to the Russell 2000 looks like it may have actually bottomed and could be turning higher. This would suggest that the market is now favoring the entire small-cap space, which implies that the market thinks zombie companies have a chance at survival.
I think it’s too early to tell if this is the case.
What Does This Small-Cap Stocks Indicator Mean?
Yes, the ratio does seem to be bullish in favor of non-cash-flow-positive small-cap exposure, but against that is quite a bit of outperformance in utility stocks and gold. As I argued last week, this still means bears are in control. Volatility was absolutely crushed last week, but now looks like it could revert higher. In other words, other market-based indicators are not as convinced that we are out of a risk-off period yet. If the market is betting on broader small-cap stocks to work, it shouldn’t simultaneously be favoring defensive behavior.
This all hinges on whether Federal Reserve Chair Jerome Powell has been able to stick the soft landing. Personally, I find it hard to believe he has given multiple lags which could hit out of nowhere.
Still, it’s worth paying careful attention to this dynamic just in case. There could indeed be an optimistic bull case where small-cap stocks finally get their long-awaited run higher, led by the areas that held small-caps back the most. I just would like to see utilities and gold weaken first before concluding that we are back to a risk-on state.
On the date of publication, Michael Gayed did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
