Why Small Caps Will Charge Forward and How High
And what is going to happen with the rest of the market
Front page headlines last week positioned the market’s rebound as a debt relief rally. Maybe the market breathed a sigh of relief. Perhaps. More accurate is to say we are in a rotation. We are seeing a catch-up rally in parts of the market that are lagging. It is after all a market of stocks.
Read on to see why small caps are best positioned to win over the next 1-2 months and how high they could rise. First, we will lay out some important market pieces of the puzzle and then focus on the small cap play. We will cover the following in this week’s article:
👉 The Debt Ceiling Aftermath & Shadow Banking
👉 Nasdaq and Mega Caps Slow Down
👉 S&P 500 So-So Returns
👉 Winning With Small Caps 💸
Debt Ceiling Aftershocks, Shadow Banks, and the Fed
Summary: If the Treasury sucks money out of the market, it will most likely come out of mega-cap tech. The liquidity drain would not hit regional banks as hard since the shadow banking system buys large volume of Treasury bonds.
Treasury Money Sponge
With the debt deal done, we are hearing much about the $500 billion being sucked away from the system as the Treasury sells bonds to refill its drained coffers. The thinking is money goes away from stocks to treasuries as banks sell holdings and reduce credit to buy these Treasury bonds.
This explanation is misguided and simplistic. Some money may come out of the economy but I don’t think it is as large or quick as projected. Why? Because there is extra money sitting on the sideline in the shadow banking system.
What are the shadow banks? Are the shadow banks a secret cartel that governments have been hiding from us? No. But they are important. 👇
Shadow Banks
Shadow banks are a feature of the current economic system and popular media seems to forget about these when discussing the Fed and the banking system. They are part of the reason that higher interest rates have not slowed the economy yet and an important reason that GDP (growth) is still not negative in the US.
Even though the Fed has tightened the money spigot, there is plenty of cash and credit sloshing around.
Nearly half of global assets are now in the shadow bank system.
What is a shadow bank you ask? They are neither hidden or banks. Shadow banking has stepped in where the government and the traditional banking has left a void.
They are financial institutions who do not have the federal reporting requirements of banks but often lend money into the economy. This includes insurers, pension funds, brokers, money-market funds, pension funds, sovereign funds, and corporate treasuries.
Another name the financial media for some of these non-bank lenders includes private credit investors.
Even you and I could be part of the shadow banking system! I have invested money through Lending Club, which is a peer-to-peer lending platform (the returns have been good). This is an entire industry that is part of the shadow banking system.
By supporting the economy shadow banks have prevented a drop in jobs thus far. 👇
Jobs & Interest Rates
One last piece to consider before discussing the markets. We need to understand the reality of the employment market in America and what it means for the stock market. We had a strong jobs number on Friday. But strong jobs number matter to the economy and will have big impact on smaller companies. We will come back to that later.
How do jobs numbers impact the stock market? Up until a month ago, every time it was high the market went down. Now it doesn’t matter much anymore.
The first reason is that Philly Fed Reserve Bank President Patrick Harker said “we can at least skip [hikes] this meeting [in June]”. Secondly, job growth is not as aggressive as it seems with the unemployment rate ticking up to 3.7% and wage growth, an important part of inflation, slowing to 4.3%.
The cost of things, including wages, is what the Fed cares about most. The Fed also has a mandate to increase jobs but price stability is a primary focus. Now the Fed said it will not increase rates but with the jobs number the Fed is unlikely to drop rates.
To that end, the market expects Fed to keep rates where they are at least to the end of the year.
Which is important when you think about mega-cap growth stocks. 👇
Nasdaq and Mega Caps Slow Down
Summary: Interest rates make bonds more valuable as they rise. Bond yields are risk free. The higher they go, the less appetizing tech is when it zooms into the stratosphere.
Higher interest rates for longer are like gravity for growth stocks. Higher rates slowdown how much money is available in the system by providing alternatives investments like bonds and reducing capital available for growth companies.
Think of it this way. If I am large institution and I can buy a bond that yields 5%+ risk free why would I want to own the stock market if it earns an average of 8% per year. Investing is about the odds. Yes the Nasdaq went up 30% but probability says in a world of only 1-2% GDP growth future huge returns in the next year are slim.
Plus! Bonds are again much safer than equities. Look how much the Nasdaq dropped last year. If I bought on Jan of 2022, I am still down -10%!
Now bonds. If I buy now I can lock an annual return of 5% AND if the Fed drops rates, my bonds will go up in value. Why? If future bonds give a lower yield, my bonds today are worth more (last year the opposite happened as the Fed raised rates and future bonds earned more than previous bonds).
For this reason how many buyers are left after the Nasdaq’s launch into the stratosphere? After a blistering 4 week run (see the QQQ ETF in figure below), it is approaching highs of Mar 2022 and could take a breather.
The gains investors have from the Nasdaq this year serve as a very convenient checking account. With the upcoming $500 billion treasury sales pulling liquidity out of the system, we could see large cap investors move recent tech gains into high-yielding and well backed US treasury bonds.
One thing to remember, pullbacks in price are a healthy market behavior. It is not a bubble bursting. TS Lombard's Andrew Cicione explains, "The hype around AI risks creating the second tech bubble in just three years [is overdone]…there are no signs of 'absolute insanity' in stocks, at least for now." Cicione points out bubbles don’t happen when the Fed pulls money from the system.
S&P’s So-So Returns
Summary: The S&P is needs more buyers and just like the Nasdaq there might be some exhaustion after all the recent excitement.
The larger capitalization growth names in the S&P could also see a pullback for the same reasons as the Nasdaq. It just not as big of a concern. The S&P has a technology representation (26% of the index) versus the Nasdaq (nearly 60% of the index).
The less tech heavy S&P 500 (as measured by the SPY) is at a YTD high and has finally breached the important $420 level. For a year the price couldn’t get above this level. Whenever prices approached this level, investors were motivated to sell. This is commonly referred to as resistance.
Bottom line. This drops mildly before resuming a path higher.
The real opportunity available is with small caps. 👇
Small Caps
Summary: Oversold levels, a pivot with high volume, FOMO on YTD returns, and protection from Treasury sales could drive small caps higher for a few months. Slowing wage growth is a sigh of relief for small cap firms. An 8% run is possible.
As far as I am concerned small caps in the near term have survived in an extinction event and are showing life once again. Here are 5 winning reasons.
Looking back to March 2023 at the S&P chart 👆, the S&P continued higher after hitting a value $379 for the 4th time and just kept on rising. The small-cap Russell 2000 index (represented by the IWM ETF below 👇) is now bouncing off the $170 price point for the 5th time in 1 year.
Volume is also an important signature with a change. Zooming in, If we focus on a daily chart and look at the volume, we see that Friday's huge move was on significant volume (blue arrow in lower pane below). The buying was strong throughout the day and especially through the end of the day (intraday price action not shown). This is significant because institutions tend to trade at the beginning and end of the day.
Let’s also not forget FOMO. The fear of missing out.
Small caps have been unloved this year and are cheap. Investors who missed out on the large cap run higher have one last area to chase - small caps.
Remember the concerns of a market sell-off because of the Treasury sale? It would hit mega caps and large caps, large banks and non-banks favorite most liquid checking account. Small caps maybe spared if this sell-off occurred. It is also a potential source of safety if this occurred. We are always searching for protection when investing.
A golden nugget for smaller companies in the jobs report is slowing wage growth. Compensation costs for smaller companies has a larger impact on profitability than for larger companies. Larger companies can invest in technology and cut out management fat if they are run well. Smaller companies are more lean and can’t move as many levers. Slowing wages reduces costs (this article is older but the concept is still valid).
How high could small caps go? They could get to the highs of the year. That is 8% higher from the close on June 6.
If you have any questions, leave a comment. Thanks for reading Embrace the Chaos! Sharing perspective that makes sense.
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- Vikas Kalra, CFA