Safety Trade is Getting Dangerous

The Russell 2000 small-cap index is up nearly 11% so far this year, while the venerable old S&P 500 is up only around 5%.  The disparity is due largely to the trade war, and investors have bought the stocks of small capitalization American companies with great vigor.  The normal correlation between markets has been tossed out, it seems, and the relationship has turned inverse. Anytime the S&P 500 looks weak, the Russell 2000 has a good day.  Investors are forgetting a few things about business economics, and that is a very dangerous mistake to my way of thinking. One thing we need to remember is that small companies have supply chains just like large companies, and these are rather limited in comparison.  

We are essentially blind when it comes to knowing where what companies get what materials.  If a small knife company in Wisconson needs a certain type of steel, the can’t be too picky where they get it, and they don’t have the bargaining power to drive the price down.  They will pay the market price. If GM and Ford are having problems with the plentiful steel that car parts are generally made with, we can only imagine the trouble that small manufacturers that require specialized materials are having.  What percentage of the small-cap supply chain is dependent on our foes in the trade war? Estimates abound, but these are largely derived using the SWAG method and are no basis for careful analysis.

Another key issue is margin expansion due to increased demand.  If investors are flooding into small-cap stocks, there aren’t enough to go round.  This drives prices up substantially, and those already in the space have a great year (so far).   As much as it pains me to admit, the vicissitudes of politics do have a huge impact on the valuation of companies, both large and small.  With the 2018 midterm elections on the horizon, the political pressure is on to demonstrate to the world that the GOP is indeed Making America Great Again.  

Regardless of how good the deals we can get really are, I predict a massive streak of deal signing and a commensurate amount of back patting and acclaim that the deals are great.   Democrats will attack the deals as smoke and mirrors. The truth, as always, will be somewhere in the middle. Regardless o how good the deals are, it will have a calming effect on Wall Street as the uncertainty level drops.  When that happens, traders will see that the small caps have run, and there will likely be a rotation back into large-cap multinationals that have been hurt by the trade war.

I don’t mean to retract my previous predictions that we are nearing a downturn in the broader economy and a big scary pullback in equity prices.  I do, however, agree with Ray Dalio’s timeline and think it is a bit premature to start yelling that the sky is falling. There is a high probability that we’ll see a bit more euphoria and another big rotation before a broad downturn occurs.  I think the next big boom will be back into the out of favor sectors damaged by the trade war, so the industrials and emerging markets will have a few days in the sun.

Regardless of where the money goes, it will come out of small caps. The more I hear watercooler talk of getting into the small-cap space the more I think that the space is overbought.  I recommend getting out of the space and looking toward the beat up sectors, especially emerging markets. I also like Canada and the financials at this stage.

With the FANG earning season in shambles, there may be a sale in tech in the near future.  I would wait for a massive pullback before entering that space as it has flown to amazing heights.  Big moves from recent values don’t necessarily reflect meaningful moves relative to fair valuations.  I am very wary of the upward move in Amazon as the EPS move was truly spectacular, but revenues were essentially flat.  Letting large sums flow down to the bottom line doesn’t tell a growth story, it tells a story of maturity. Amazon may be the retail business equivalent of a bulldozer, and we need to remember that bulldozers aren’t nimble.

I recently closed out my leveraged biotech position, and am holding financials and energy.  I’m short both the Russell 2000 and the S&P 500. I’m also sitting on a lot of cash, waiting on that sale.

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You may also be interest in a section of my book entitled Take Some Off the Table.

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