Microcaps Are Exploding

Monday’s stock performance was shocking given the recent run the small caps and micro caps have been on. The Russell 2000 was up 1.25% which means it’s up 11.24% since August 21st. It has been up 7 days in a row and 23 of the last 28 days. The Russell 2000 14 day RSI is at 84.17 which is the highest since October 1987. I think a correction will occur this weak based on this extreme momentum. The other indexes were all green as the S&P 500 was up 0.39%. They all hit record closing highs. The VIX’s 9.45 close is the 5th lowest in history. The KBE bank ETF is now up 12 days in a row which is the longest streak in its 12 year history. The streaks I’ve mentioned thus far pale in comparison to the chart below. The micro caps have gone from flat to up 11.2% on the year.  As you can see, they’ve only been down 2 times in the past 30 days. This is a parabolic move that should be sold if you still own a position in the microcaps. Even if you don’t usually trade stocks, a 14.48% return since August 17th isn’t sustainable. Experience shows parabolic moves are usually end in tears.

One of the possible motivations for the rally in small caps could be the tax cuts. I know that the indicator which shows the companies that benefit from tax cuts aren’t rallying, but it’s still a possible catalyst for small caps. This is why looking at the chart below which shows the historical stock market reaction to tax cuts can be helpful. As you can see, the tax cut was passed in October 1986. Stocks got too excited about the plan as they rallied excessively in 1987 before the famous October 1987 crash. Then stocks rebounded as they increased alongside earnings. We are seeing a sharp rally in small caps that might be overly optimistic. The tax plan hasn’t even passed yet, making this rally even more speculative than the one in 1987. The difference is that small cap earnings are increasing unlike in 1986 when S&P 500 earnings were stagnant. I don’t have access to the earnings of microcaps, but the Wilshire Micro-cap ETF had a PE of 15 at the end of Q2. I wouldn’t use that data point as reason to be optimistic about microcaps necessarily. It’s also worth noting how volatile microcaps are compared to the S&P 500. The microcaps rally and crash more often than the large caps.

Record Investment?

The decline in fixed investment has been catalyzed by the lack of high wage growth this cycle. There’s not a big need to invest in new processes to make workers more efficient if wages aren’t a big cost problem. Obviously being more efficient is always a positive, but that money could be spent on other things or returned to shareholders. We’ve seen a moderate pick up in wage growth in some sectors this year. Manufacturing firms have discussed not being able to find enough qualified workers. Whether that translates into higher paid workers doesn’t matter to these firms because either the costs will be high or there won’t be enough workers at the companies. In both cases firms need to be more efficient. If workers become expensive, investing in capex will save future costs. If workers can’t be found, being more efficient is a necessity to get the production done. The chart below shows the diffusion index created by the Philly Fed. As you can see, the capex investments have reached the highest point since the mid-1980s. This is only in the Philadelphia district, but it’s a good sign for the economy as a falling capex diffusion index usually correlates with recessions.

(Click on image to enlarge)

Is Yellen Sending Microcaps Higher?

As I have previously discussed, one of the reasons small cap indexes have been rallying is because financials are heavily weighted in them. In the Wilshire Microcap index, the financials are the top sector with a 26.82% weighting. Technology is only weighted 13.12% which is slightly over half the weighting in the S&P 500. The 23.17% technology weighting could be why the S&P 500 is lagging the Russell 2000 as tech stocks have been weak in September. The dollar has been rallying along with bank stocks as you can see from the chart below. Both have been following the increased expectation of rate hikes. As we have discussed, the December rate hike is very likely and the Fed will be starting the unwind of its balance sheet in the next few days.

Along with this shift in policy, the chances of Yellen being picked as Fed chair have fallen sharply in the past few days. She’s in 3rd place in the betting markets with a 17% chance of being picked. I always thought her and Cohn were overvalued. We’re seeing that opinion being proven correct as Cohn is now at 16%. The top two choices are now Warsh and Powell with 34% and 29% odds respectively. Warsh is a hawk who would raise rates possibly more than what the Fed’s dot plot indicates. That would further boost financial stocks and small cap indexes which heavily include them. The selloff in tech also makes sense because that sector does bad with rising rates. I still think the market overall isn’t properly reacting to a potential hawkish Fed in 2018. The S&P 500 should get a lower multiple if bond yields are going to be rising.

Conclusion

The stock market has begun to price in the positive results from the potential for tax cuts and a hawkish Fed, but few of the negatives. This had led to extraordinary action in the microcap stocks which is likely unsustainable. If you are an investor looking at individual small or micro cap names, I would be patient and wait for a substantial pull back before making a purchase. Good news should push these small banks higher, but at the same time the tax cuts haven’t passed Congress and no one has been selected as Fed chair yet.