Home / News / World /  Small cap stocks soar ignoring bleak US economy

To best observe the real-world impact of Federal Reserve largesse in the stock market, maybe focus on its fringe.

That is, places occupied by companies whose lease on life is weakest: small-cap firms that don’t make any money. Since equities bottomed around the time Fed Chair Jerome Powell pulled out all the stops to shore up markets, shares of these so-called zombie firms haven’t just rebounded. They’ve risen twice as fast as profitable ones.

No more vivid illustration exists of how twisted markets have gotten in 2020, when ailing companies don’t just scrape by, but thrive. It’s a consequence policy makers will have to live with in their resolve to save the economy. Investors are happy to play along, doubling down on the riskiest stocks.

“The Fed won’t let me lose money’ is the mantra," said David Spika, president of GuideStone Capital Management. “When you push interest rates to zero and you flood the market with liquidity, you’re daring investors to buy the riskiest assets they can -- and they’re taking them up on it."

First, the central bank did an emergency rate cut. Then it set massive bond purchases and a slew of emergency facilities to bolster credit markets. It coordinated actions with foreign central banks to ease the supply of dollars worldwide and established programs for lending directly to American businesses. And that was just March. Later it bought ETFs for the first time while its balance sheet swelled to around $7 trillion.

As insolvency risk subsides amid that torrent, investors have flocked to unprofitable companies. As of the end of last year, 38% of Russell 2000 constituents were losing money. Since the market’s trough in March, their stocks have rallied about 79% on average. That compares with 47% for those that are profitable.

While many of the very biggest winners have products that could be viewed as stay-at-home champions, such as Inc., investors have also found a lot to like recently in companies like Sientra Inc., a plastic-surgery device maker, Century Casinos Inc., AgroFresh Solutions Inc., and Greenlane Holdings Inc., a cannabis and tobacco accessory distributor.

To be sure, the outperformance is part and parcel of a broad recovery trade where stocks beaten down most during the pandemic are coming back as some of the biggest winners. From airlines to energy and cruise lines, companies expected to suffer losses are doing the best in the rebound after the Fed’s moves facilitated easy access to credit, mitigating the threat of bankruptcy.

But this isn’t the way it usually works. A study published Wednesday by the Leuthold Group showed that over time in the small-cap space, it has paid to own the highest-quality companies, including those with the best record of profits.

“Part of the reason quality wins so much is just over the long-run, earnings power drives stock prices and speculative juice doesn’t last long," said Scott Opsal, the firm’s director of research and equities. “Eventually we’re going to roll into a period where profits matter, growth matters and maybe companies losing money quarter after quarter won’t seem as exciting as they are today -- that’s when small-cap investors may flip back to the quality firms."

Asked last month if the Fed was helping to inflate markets, Powell said in a news conference that the central bank’s focus is the economy, the labor market and inflation, rather than the movement of asset prices -- in any direction. While St. Louis Fed President James Bullard said he’s keeping an eye on the markets, he’s not seeing anything akin to prior bubble incidents.

Bubble or not, it’s an unsettling sight to watch the ranks of unprofitable companies growing while their stocks keep rallying. In the second quarter, where the number of loss-making companies are expected to increase to 43% of the Russell 2000, the benchmark jumped 25%, the best gain in nearly 30 years.

Fretful investors fear the bonanza could create pain down the road should monetary stimulus stop or the economy fail to rebound as fast as expected. Already, there are signs a V-shaped recovery may not materialize. JPMorgan Chase & Co.’s CEO Jamie Dimon warned of just that Tuesday, saying traditional recessionary effects have been masqueraded by stimulus, for the time being. Worse could still await.

“At some point the companies that are hanging on by a thread are going to declare bankruptcy," said GuideStone’s Spika. “We’re going to have to pay the piper."

This story has been published from a wire agency feed without modifications to the text. Only the headline has been changed.

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