Historically, the Russell 2000 has gained an average of 1.3% in the month after entering correction territory

Small-cap stocks just hit a market milestone they'd rather avoid.

Buckle up: Small-cap stocks just hit a market milestone they'd rather avoid.

The Russell 2000 index RUT on Wednesday entered correction territory, logging a drop of more than 10% from its August peak, as surging Treasury yields BX:TMUBMUSD02Y and expectations of several Federal Reserve interest-rate hikes to tame inflation weighed on small companies that rely heavily on borrowing and floating-rate debt to finance their businesses.

A market correction is generally defined as a decline of at least 10% from a peak, while a drop of at least 20% marks the threshold for a bear market. Settling at 2,729.53 on Wednesday, the Russell 2000 index was down over 11% from its record close of 3,068.42 set just two months ago, marking its second correction-territory entry this year, according to FactSet data.

"Rates started really to tick up around Aug. 14, and that coincided with a high on the Russell 2000, so small caps' underperformance really started to occur when the high velocity of rates started to become embedded in the market story," said David Wagner, portfolio manager and head of equities at Aptus Capital Advisors.

Interestingly, small caps were performing better than large caps just two months ago. But lately, large caps have taken the lead. What changed is that investors worry that higher borrowing, sticky inflation and rising energy prices (CL.1) (BRN00) could keep interest rates higher for longer. That backdrop has made large tech companies with stunning earnings feel like much safter plays.

Unlike their larger peers, small-cap companies also often rely more heavily on floating-rate debt, instead of locking in borrowing costs through longer-term, fixed-rate bonds. That leaves more of their debt exposed to changes in short-term policy rates.

In Wagner's view, the selloff in small caps also shows how "bifurcated" the stock market is right now. "You have the AI names, specifically the clouds, really holding in there because they are very rate-agnostic," he told MarketWatch in a phone interview on Wednesday. "But the market underneath the hood has still been affected by interest rates."

To be sure, it's not necessarily how high interest rates are that hurts stocks. It's how fast they get there, Wagner said. A sudden surge in rates can force investors to rapidly mark down stock valuations.

For example, a 10-year Treasury yield BX:TMUBMUSD10Y sitting near 5% for months may not do much damage to equities, but if the rate suddenly jumps to 5% from around 4% over a short period, that can put non-tech stocks under pressure.

Still, a look at the past six years of corrections for the Russell 2000 shows such pullbacks have been pretty frequent, but mostly short-lived, as the below chart shows.

Since 2020, the Russell 2000 has gained an average of 1.3% in the month after making its correction-territory entry, while the average advance in the next two months has been a notable 5%, according to Dow Jones Market Data.

And of the nine previous times the small-cap index entered correction territory over the past six years, only three turned into bear markets.

U.S. stocks finished mostly lower on Wednesday after a hotter-than-expected September inflation report triggered big swings in Treasury yields, while investors grew deeply concerned that some cloud-computing companies, like CoreWeave (CRWV), relied too heavily on massive debt and capital spending to build out their AI infrastructure.

The Nasdaq Composite COMP and the S&P 500 SPX were off 1.9% and 1.1%, respectively, logging their worst days in about three months. The Dow Jones Industrial Average DJIA fell less than 0.1%, according to FactSet.

Mike Destefano contributed

-Isabel Wang