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A Bull and Bear Case for the Little Guys — Small Cap Stocks in Global Markets.


The Market Twilight Zone Continues

As Twilight Zone market conditions of suppressed volatility, low rates, central bank steroids and nosebleed valuations continue to test the headwinds of a geopolitical circus in DC, including a looming debt-ceiling, the near impossibility of revenue neutral tax cuts in the US, and an asset bubble world created by global debt to the tune of $240T, many of us keep an itchy (yet nervous) finger on the daily trade sheets, going long (and occasionally short) until common sense or sophisticated trade signals suggest otherwise.

Recently, I’ve been striving to play both the prosecutor and defense—that is both bull and bear—in analyzing opportunities and risks in this surreal market, which since the steroids kicked-in after 2008, just doesn’t seem to go down…

Our investors have been asking a lot about small cap stocks, and without giving away any trading signals here, I can nevertheless offer a bull and bear case for this unique asset class, leaving just enough hints as to my own bias, but equally enough ammunition for you to draw your own conclusions.

Small Caps: A Bull Case

There’s plenty of evidence in the rear-view mirror to justify the power of the “small cap effect.” That is, we have seen how small cap stocks consistently outperform large cap stocks over the long run. Indeed, even David Swensen, the guru of the Yale Endowment, has admitted that but for Yale’s Trustee’s and other risk metrics imposed upon him, he’d otherwise invest in nothing but small cap stocks.

Wow. That suggests a lot of faith in small caps. Swensen, moreover (and not surprisingly) has the data to back this up. He goes as far back as 1932 until the end of 2006 (an interesting end-date choice…) to reveal a small cap rise of 1592-fold. He compares this against the 19X return for US T-Bills during the same time period…

Other analysts, academics and traders have added to the fervor. Eugene Fama, the 2013 Nobel Prize winner in Economics, looked at small caps between 1963 and 1990, and concluded that this asset class produces higher returns, but with higher risks (Hence Swensen’s capitulation to Yale’s Board of trustees…).

The outperformance might be due to market inefficiency, as small caps are not as covered by Street analysts as the big names. Small caps, moreover, are quicker to dive in turbulent conditions.

Looking back the last 10 years in our own markets, the Russell 2000 (the barometer of 2000 US small cap stocks) has done fine, but not in a mind-blowing way. It has gained about 8.5%, just shy of the S&P’s 8.65% average for the same period.

Overseas, however, the numbers are more compelling. Since the 1950’s, UK small caps have annualized at 16% against the 12% broader index returns. Globally, small caps have outperformed large caps 89% of the time in five-year rolling periods. In sum: small caps have a compelling history of outperformance over the long term—with greater bumps along the way.

If you have the discipline for such bumps and a faith and patience for long term reward in growing US and/or global economies, you may want to buy some global small caps, of which the iShares MSCI EAFE Small-Cap ETF (SCZ) is (and has been) a strong outperformer.

Small Caps—A Bear Case

But before you dial up your broker, you may want to hear the counter-argument to the small cap effect. First, and most obviously, there’s the phrase that surfers around the world know all too well, namely: “Dude, you really missed a great swell. You shoulda been here yesterday.” The small cap stocks have gone from great to one of the worst performing indexes of the year…

In other words, it’s possible, for now, that the small cap wave has passed and we are looking at more risk than reward going forward. As in all asset classes, the smart money buys at bottoms, not volatile tops.

Given the strong possibility that markets are due for a correction (for countless reasons), and given the fact that small cap stocks get temporarily pummeled in market corrections, one might want to wait for a real dip rather than a reliance on more momentum in these Twilight Zone markets.

Going into Q2, the Russell 2000 was valued at 28X forward earnings—hardly a “bargain” price for value traders…If you were to exclude companies with negative earnings, that multiple dropped to 20X, which was still nothing to brag about…

The folks at MarketWatch, however, who have been smell-testing bogus valuation practices, are convinced that the over-valuation is much, much greater for the RUT.

Small caps, moreover, are worth buying at a premium if you believe the economy is going to show continued growth. The fact that the Russell 2000 had grown by more than 20% since the Trump victory only to tank by mid-August certainly suggests that the Trump pledge for infrastructure spending, tax cuts and de-regulation and thus further US economic growth has lost some of its fervor/faith.

Stagnating GDP figures for the US do not support this hope-driven rally. Furthermore, if you are less than optimistic about the possibility of tax cuts, de-regulation and infrastructure spending in the current DC swamp, than you may want to reconsider a long-play in small caps for now…

Then, of course, there’s that secret little bank called the FED, which conducts its mercurial rate adjustments with astounding hubris and myopia. When and if rates rise from the artificially compressed zero-bound, this would be a brutal headwind for small caps.

I’ve written elsewhere (July, 2017) as to my own view on the Fed and the Russel 2000…. And called the RUT a good short, rather than a good long. The following month (Aug. 2017) confirmed the sentiment—and the trade…

Small caps have under-performed in four out of the last five Fed-tightening cycles. As the central bank faces low credit spreads poised to widen, rate hikes are likely, as are headwinds for this asset class.

Bottom Line

The bottom line is this: small caps depend on either a faith or reality that the underlying economy is going to grow. In the US, as well as abroad, you will need to determine for yourself if such a faith or reality seems more or less than likely—and thus favorable for small cap stocks.

You decide.

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