What to Make of the Nascent High-Rate Fear Morph

We have written a lot about the sentiment phenomenon we call the Pessimism of Disbelief since this bull market began in October 2022—in a nutshell, it is the mentality that makes investors loath to acknowledge any good news. Even when big fears don’t come true, when the Pessimism of Disbelief reigns, folks don’t acknowledge it. Instead, the fear morphs and the wall of worry gets more bricks. The latest example, courtesy of Thursday’s Wall Street Journal, is the conversation surrounding small and large cap.

As the article notes, small cap (represented in this case by the S&P 600) is a smidge ahead of large cap (S&P 500) since this correction’s lowest point to date in late October, but large is still trouncing small on the year. All fair and factual. Here is where things get interesting: The piece pins small cap’s disappointing 2023 on high interest rates and warns more lackluster returns are in store. “About 40% of the companies in the S&P 600 have outstanding floating-rate debt with shorter maturities, compared with roughly 10% of companies in the S&P 500, according to the J.P. Morgan Equity Macro Research team. Even if the central bank is done raising interest rates, small-caps likely won’t see any relief from higher interest expenses until rates start falling. After that, there will be a lag because most of the floating-rate loans issued by public companies reset quarterly and are backward looking.”^[i] Meanwhile, it noted large firms “are generally more insulated, after many rushed to lock in low fixed rates in 2020 and 2021,” and quotes an analyst who describes their cash-rich balance sheets as a “moat.”

We think these are very salient observations about large firms—especially the growth-oriented giants in Tech and Tech-like industries. Funny thing: We have been pretty much alone making these same observations for the past year-plus while seemingly the entire world was busy arguing high rates were bad for growth stocks in general and Tech in particular. Ignoring those giant cash buffers and locked-in low rates, pundits argued high long rates rendered the companies’ future earnings less valuable, removing the rationale for high valuations. You can see our most recent rebuttal here.

And now, as the Journal piece notes, large firms have bounced and are still leading on the year. We would add that through yesterday’s close, S&P 500 Tech stocks are leading both the S&P 600 and S&P 500 Indexes since October’s low. But instead of couching this as a powerful counterpoint to the earlier high rates kill growth stocks worries, the article omits those prior fears entirely, cites growth firms’ plusses in passing, and zeroes in on long rates instead being bad for small cap. Rather than conceding the prior fear was false, the piece omits it and a new fear takes its place.

We point this out not as a giant we were right or to call out any paper or commentator in particular, but to show how much the narrative has changed without sentiment becoming materially sunnier. Instead we get the classic Pessimism of Disbelief fear morph—a good sign, in our view, that stocks have a nice big wall of worry to climb.