The stock market had another move higher on Tuesday as my near term bearishness on the small caps and microcaps has been proven incorrect. The Russell 2000 - RUT is now up 8 straight days and the IWC microcap index is up 29 out of the past 31 days. We are certainly in one of the calmest stock market periods ever. The chart below gives you a glimpse at the animal spirits in in the bond market. As you can see, the Bank of America Merrill Lynch investment grade index has a yield spread of 106 basis points which is the lowest in 10 years. The emerging market credit spread is also tight. It’s at 418 basis points which is the tightest in over 10 years.

Obviously, the Fed plays a part in this extraordinary action. The chart below paints an amazing picture. As you can see, the Fed funds has historically risen whenever the ISM manufacturing did well. Sometimes the Fed’s response was delayed and sometimes it was muted, but it always occurred. This cycle has been unusual as the ISM has risen twice without any action from the Fed. This time it’s the highest in 13 years and there has only been a modest amount of hikes. There’s a possibility the Fed has kept rates too low, creating another bubble. It solved the previous crisis by overcompensating on monetary policy, leading to an uncertain future. There’s no comparable point in history to such policy. Rates should be lower than in the 1970s because inflation is lower, but that doesn’t excuse this extreme policy. The only thing we know for certain is that this period will be studied by monetary policy historians and policymakers for  a long time.

The biggest worry is about how easy it is to access capital. There needs to be standards when it comes to capital allocation. We can’t have too much money flowing to people/businesses who can’t pay it back. It would be like if everyone was dying to give payday loans at a 5% interest rate. That type of risk would bring systemic risk to the economy. That type of situation occurred in the 2010s with fracking companies. When oil prices fell, we saw the chickens come home to roost for the banks and investors who gave drillers money who needed oil to be at high prices to keep operations going. The oil market was small compared to what could happen during a recession. The chart below gives you an idea of the size of the potential problem. As you can see, the annualized leveraged loans are $539 billion in 2017 which is higher than the 2013 peak which was driven by energy. This sustained period of leveraged loan issuances is like repeating 2007 many times. That doesn’t necessarily mean there will be a recession of the same magnitude as 2008. It will be different, but the size of the leveraged loan market is disconcerting.

(Click on image to enlarge)

As we focus on the individual economies of Texas and Florida because of the natural disasters, it’s important to recognize that many parts of the country haven’t recovered from the recession. The chart below shows how the Midwest has been decimated, while Seattle thrives. That’s why Seattle’s housing market is the hottest in the country. There’s demand from employed people. Amazon - AMZN plays a big part in the economy of Seattle and other tech firms play a big part in the economy of San Francisco. The boost in job creation in Seattle is why so many cities are pulling out all the stops to get AMZN to move there. The obvious question is why these cities don’t try to make the same type of benefits available to all businesses. At that point, the city wouldn’t need Amazon because small businesses would thrive. Unfriendly taxation and regulation policies for businesses are partially why areas like Youngstown, Ohio can’t recover. Either way, whichever city gets to be the location of Amazon’s second headquarters, that city’s economy will experience a spike in employment. It will be sustainable like the growth in Seattle and unlike the weakness in Florida and Texas. Obviously, it’s dependent on the success of AMZN. The company plans to hire 50,000 workers for the new headquarters and 100,000 throughout the country at fulfillment centers.

One important aspect that needs to be touched on when we discuss these hugely successful technology companies, is the current situation of monopolies and oligopolies implies that the small firms might be getting squeezed or bought out. As you can see from the chart below, AAPL, AMZN, FB, and GOOG have monopoly level market shares in some of their business segments. The risky aspect for some of these businesses is how regulators might come down on them. This is pressure that Microsoft and Intel have felt previously. The other aspect to consider is that technology is highly fluid. It was once thought that Oracle dominated the enterprise software market and then Salesforce.com came in and utilized cloud computing to change the game. A final idea to ponder is if America is becoming a country dominated by big corporations. Because of all the mergers, the top 4 banks in America have huge control. In technology and finance, there has been a centralization of power. That could be dangerous as the American economy has traditionally been founded on small businesses.

(Click on image to enlarge)

Conclusion

Animal spirits are driving the market as we’re seeing yield spreads tighten and small caps explode to the upside. That has been helped by the Fed which has kept rates low despite the great ISM results. This has led to an extremely high amount of leveraged loans being given out. The economy is broken up into parts. Middle America has been decimated by outsourcing, while the cities with energy and tech companies in them have outperformed. The tech companies of today control how the economy does. That can be a good or bad thing depending on your thoughts of these firms’ business models.