I'm Wrong When I Am Proven Wrong
Over the last few months I think you have figured out my thing. My thing is to put out a periodic opinion piece where I rarely give you the data to back it up but if you actually take the time, you can easily find what I am talking about and understand that while it’s pretty much all opinion, I don’t just pull this stuff out of thin air. I try to keep my posts short and rarely bog it down with the facts to back things up. Is that me being lazy? Absolutely, but what it does is give you a five minute read on something. You care, you dig deeper. You agree, my job is done.
No matter how the market ends up today or this week for that matter, I still feel very strongly that we are due a correction. Looks to me the small caps agree since they are in correction territory and small caps tend to be much more sensitive to negative economic conditions than mid cap or large cap stocks. Conversely, that does not hold true in with respect to positive economic conditions. Generally, money flows in good times to the big names making big splashes while the small cap names flounder for a bit and then as money searches for return and higher risk, it goes to small cap names. Yet, when things get a little dicey, those small cap names tend to be the first to get hit. Last in/First out.
Trust me, I don’t look at weakness in small caps as a sign of any one economic trigger but it does show a vulnerability to the market and can be used to predict large cap movements down the road.
Some people will argue this theory and say that a flight out of small caps means a flight to the relative safety of large cap names. Sound logic but here is where it doesn’t hold water.
If there is a movement out of small caps big enough to put the Russell 2000 in corrective territory does that mean that that money will push, let’s say the S&P 500 significantly higher? I say no. The dollar value coming out of illiquid smaller stocks most likely has a limited impact on the movement of much more liquid (and expensive) large cap names. Without digging too deep in the weeds here just imagine if you will, owning one share of every Russell 2000 stock, sell it and figure out what that cash can buy relative to the S&P 500. Not much. Simply put, the dollar value coming out of small cap indexes has very little impact on large cap indexes.
To make it even simpler, the total value of the Russell 2000 is roughly 1.9 trillion dollars. Nothing to sneeze at but a loss of 10% of the value of that index works out to be around 190 billion dollars. Dump 190 billion dollars into the S&P500 index (assuming that is where all of it is going) and you have a less than .005% bump in the index. So Virginia, a simple guy like me debunked half of the talking heads on CNBC with my high school math.
Going back to my original thought about the small cap leading the charge out of equities is not based on any verifiable facts but my thinking is that investors tend to dump the chaff first, when things begin to get prickly and thats what we have seen. Getting out of names that will be impacted more severely by interest rate hikes and tightened money supply. Mid and large cap companies are interest rate sensitive for sure but having had this extended period of low interest and free money supply has allowed those companies to have much longer, much lower debt cycles where small cap companies continually used funding from shorter loan cycle tools and that will come back to haunt them. Again, to simplify it. ABC company which is 50 billion dollar business has repeatedly tapped credit lines at lower interest rates and longer cycles than DEF company which has a 500 million dollar business that repeatedly taps higher interest rate shorter duration vehicles. Hence, Higher interest rates will impact these smaller names more directly.
So, everyone keeps an eye on treasuries as indicators of this and indicators of that, I love peering into the crystal ball using small businesses as my guide. More prone to rising interest rate cycles, more prone to bad business cycles and because markets tend to be pretty accurate business predictors, small cap stocks are telling me that after they correct, the next logical step is mid and large cap stocks. Because December seems to generally have a life of it’s own, I will put off this theory until January. However, it will come.
I will, again remind my readers that I do not think that this correction is an indication of anything more than the true natural course of events. The economy (without looking at equity markets) is doing just fine. It’s a little disjointed as far as the recovery of businesses is concerned but that over the next six to 10 months will be flushed out and if Washington stays out of the way, we will be doing just fine.
Again, that is a huge if.