Small Growth Stocks Poised for Rebound as Bond Yields Stabilize

Introduction:
The recent downturn in small, fast-growing companies may be coming to an end as higher bond yields, the primary catalyst for the slump, are not expected to rise significantly from current levels. This development sets the stage for a potential rebound in the sector, offering investors an opportunity to capitalize on undervalued stocks. Despite the challenges posed by rising yields, experts believe that the 10-year Treasury yield has reached its peak, paving the way for a resurgence in small-cap growth stocks.

The Impact of Bond Yields on Small Growth Stocks:
The iShares Russell 2000 Growth exchange-traded fund (IWO) has experienced a 12% decline since the end of July, largely driven by the rise in the 10-year Treasury yield from just below 4% to approximately 4.7%. This increase can be attributed to the Federal Reserve’s commitment to maintaining higher short-term interest rates to combat inflation. However, this surge in long-dated bond yields has adversely affected developing companies, whose future profits are significantly devalued.

A Silver Lining for Investors:
The good news is that the 10-year yield is not expected to rise substantially from its current level. This suggests that growth stocks, particularly in the short term, have the potential to rebound. As inflation is projected to subside, the 10-year yield, which currently exceeds expectations for average annual inflation over the next decade, is likely to attract buyers. Consequently, the bond’s price would rise, and its yield would decline, providing a favorable environment for smaller growth stocks to thrive.

Rebounding Opportunities for Small Growth Stocks:
To gauge the potential rebound, let’s consider the key levels for the Russell 2000 Growth ETF. With its current price at $225 per share, the ETF has consistently found support just above $200 since the second half of 2020, while encountering resistance around $250. Breaking above this level would require market confidence in sustained lower yields.

Progyny, a provider of low-cost infertility solutions and a component of the Russell 2000 Growth Index, exemplifies a company that could benefit from a drop in the 10-year yield. Despite experiencing a 19% decline since the end of July, Progyny’s stock performance appears to be more closely tied to rising yields rather than company-specific factors. Notably, Progyny surpassed sales and earnings per share forecasts in early August, with analysts’ estimates showing a positive trend since July, according to FactSet. Should the 10-year yield decrease, stocks like Progyny are likely to rebound.

Long-Term Prospects for Small-Cap Growth Stocks:
Even if yields stabilize rather than decline, small-cap growth stocks could still perform well over an extended period. A stable yield environment would allow earnings multiples to remain intact, enabling earnings growth to drive stock prices higher. FactSet predicts that the ETF’s aggregate earnings per share will grow at a rate of just over 40% annually over the next two years, reaching approximately $10.80 by 2025. With a forward price/earnings multiple of around 30 times, the ETF could potentially trade at $324 by the end of 2024, representing a 46% gain from the current level.

Conclusion:
As bond yields stabilize and the 10-year Treasury yield is expected to remain relatively unchanged, small-cap growth stocks are poised for a rebound. Investors can take advantage of this opportunity by considering undervalued stocks in sectors such as Progyny, which have experienced temporary setbacks due to rising yields. Furthermore, the long-term prospects for small-cap growth stocks remain promising, with earnings growth projected to drive stock prices higher. By staying informed and strategically positioning their portfolios, investors can potentially reap significant gains in the coming years.