Exploring Small-Cap Stocks and Interest Rates: What the Data Say
It’s often claimed that small-cap stocks are more interest-rate sensitive than their large-cap counterparts because of their reliance on outside financing. This seems plausible. But what do the data say?
In this blog post, I explore the relationship between small- and large-cap stocks and interest-rate changes using the Stocks, Bonds, Bills and Inflation® (SBBI®) monthly dataset — which is available to CFA Institute members — and the Robert Shiller long-bond rate dataset. I use graphs and correlations (and a little regression).
Main Findings:
- Small-stock monthly returns are no more sensitive to rate changes than large-stock returns.
- Small stocks fare no worse on average than large stocks during periods of Federal Reserve (Fed) interest-rate tightenings.
- The relationship between stocks and rates isn’t stable. There are periods when equities are highly rate sensitive, and periods when they aren’t.
- The Federal Reserve Bank of Chicago’s (Chicago Fed’s) National Financial Conditions Index (NFCI) has about the same relationship with small-stock returns as with large.
R Code for calculations performed and charts rendered can be found in the online supplement to this post.
Stocks and Rates: The Big Picture
I start with the full period for the SBBI® dataset: January 1926 to April 2024. The left panel in Chart 1 shows the correlation between small-stock monthly returns and the long-government bond interest rate (hereafter, the “long rate” or just “rate”) from the inception of the SBBI® dataset in 1926 to April 2024, which is the last available month of SBBI® returns. The right panel in Chart 1 shows the correlation between large-stock monthly returns and the long rate during the same period.
These correlations are suggestive, but obviously not conclusive. The long timeframe — nearly a century — could mask important shorter-term relationships.
Decade Trends:
Table 1 shows large- and small-cap stock monthly return correlations with all long rate changes grouped by decade.
When viewed this way, the data suggest that there could be meaningfully long periods when correlations differ from zero. Correlations are usually of the expected sign (negative).
Chart 2 shows the rolling 60-month correlation between the small-, large-, and long-rate change series for the length of the SBBI® dataset. Two features are noteworthy. Small and large stocks appear to exhibit similar behavior in response to rate changes. The stock-rate relationship varies, and can have the “wrong” sign for long periods.
Could the observed similar response of large and small stocks to long-rate changes be due to the influence of “the market” (large-stock returns) on small stocks? Controlling for “market beta” does impact the relationship between small stocks and long rates.
Monetary Policy and Returns
Table 3 shows the average annualized performance of small and large stocks during the 12 Fed tightening episodes identified by Alan Blinder. Small-stock returns do not significantly differ from large during these tightenings.
Financial Conditions
Small and large stocks respond similarly to changes in financial conditions as measured by the NFCI maintained by the Chicago Fed. The relationship remains consistent regardless of changes in the NFCI.
Avoiding broad statements about small stocks and rates, the data do not support the claim that small and large stocks respond differently to rate changes. Small stocks are not uniquely vulnerable to rising rates as commonly believed.
Conclusion
This analysis of CFAI SBBI® and Robert Shiller data on long-government bond rates provides insights into the relationship between small-cap stocks and interest rate changes. Small and large stocks do not react differently to rate changes, monetary policy shifts, or financial condition variations. The data suggest that both small and large stocks respond similarly to changes in interest rates, challenging the conventional wisdom about small stocks’ vulnerability to rate changes.
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Disclaimer: The information contained herein represents independent research and does not represent solicitation, advertising, or research from Armstrong Advisory Group. While believed to be reliable, accuracy and completeness are not guaranteed.
Source: R. Fandetti, Registered Investment Advisor representative of Armstrong Advisory Group.