August...ahh..21...
August, August, August, oh why dost thou arrive so soon?
Thou art not expected for another month.
Now I must remember how old I am, and how old I shall be upon the 14th's bloom.
But my birthday is seemingly the least of worries, as we delve into what August may bring for us.
This time, instead of listing every single piece of data that proves my bias right - Let's find every piece of data that disproves my bias. Let's find a reason to short the small caps.
If you haven't been paying attention, or you are an NPC that lives under a rock and thinks a small cap is a type of hat; Well, the smalls have been having rather a lovely time recently.
In my outlook of '24, one of my major points - and effectively my entire portfolios thesis - is that smalls will outperform the tech indices this year in a powerful market rotation.
I can't say that everything I randomly guess with my grotty crystal ball comes true, but Outlook #2 is now true, the odds of a rate cut in some form for September is now effectively 100% in SOFR pricing.
https://www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html
And Outlook #4 is true, now that IWM is outperforming tech YTD and this Quarter.
Outlook #5 is my next to hopefully come true and this will be explained in another post on why August *could* be decent for bonds. Perhaps notably, TLT did bottom in May, and move up gradually in June - July, perfectly matching seasonality except that July was weaker than average.
But who cares? We want to see reasons why I could be wrong. Why this may fall face-first.
What facts or data have I missed?
Well... Let's try find some
1. Seasonally, the phrase "Small Cap Summer" has no grounding in history. Summer is the worst period for all stocks on average. It's similar to how the phrase "sell in May and go away" is completely unfounded, in fact the opposite is true.
I recommend trend spider for seasonality, they nicely provide the data for free, though paying is absolutely worth it :
https://trendspider.com/markets/symbols/IWM/
Quick clarification though - The above chart only shows the % chance the month is positive according to past average trends. It doesn't show the depth of the move up or down as an average.
To get that data I had to either code my own seasonality tool ( god forbid I have to go to such lengths ), or spend hours scrolling through pages of Google until I found seasonax - I recommend signing up for the free 30D trial, no payment needed, just an email sign up. Will probably end up paying for this.
The bull point is that on average, August is actually flat. It's September you should be more concerned about.
2. There is a big argument that Trump promotes a very much risk on market and his likely incoming presidency will fuel a spur in small caps. This is based on the previous performance of small caps and the general market under his presidency.
But the effects of QE due to covid - which is a fed decision, not Trump's - distorts the entire picture of how the market reacts to his policies.
In reality, it is unknown whether or not markets enjoy his policies.
To quote an article by $JPM -
"
Democrats presided over the best years for 10 out of the 11 sectors but without much consistency on when that occurred: financials and health care (1995), technology (1999), utilities (2000), materials (2009), industrials and consumer discretionary (2013), real estate (2021), energy (2022), and communication services (2023).
However, just as a Republican administration can hardly be blamed for presiding over the onset of the financial crisis in 2008, a Democratic administration cannot be celebrated for outsized returns in technology during the tech bubble. Therefore, it is very difficult to discern sector performance patterns under different administrations that could reliably repeat themselves in the future, even if a party is relatively consistent over time on policies they strive to implement in different industries.
"
So perhaps best to avoid using politics as a tool for the past or future.
3. Stocks tend to do quite well after fed cuts - except if there is a recession....
https://www.carsongroup.com/insights/blog/not-all-rate-cuts-are-the-same/
And recession odds aren't exactly low according to some of the best indicators out there.
Sahm rule probably being the most notable.
https://fred.stlouisfed.org/series/SAHMREALTIME
There are many arguments about recession indicators being outdated now for varying reasons, many related to the shift in economics after the pandemic, but it is often true in markets that saying "this time is different" - is very dangerous.
https://www.axios.com/2024/07/23/recession-indicators-signals-not-working-employment-trends
But then again, there are many many many indicators that track the probability of recessions, some with perfect accuracy and others are just a bit wishy-washy.
RECRPOUSM156N (https://fred.stlouisfed.org/series/RECPROUSM156N), allocates a 3% chance of a recession.
4. Small caps are just not profitable. At least....most.
It's a really common way to describe the small cap market - the index RTY effectively tracks companies you have likely never heard of and even more likely never will hear of, except perhaps on a bankruptcy filing in a few years.
Many are not profitable, and the few that are, eventually get kicked out of the Index and promoted to the higher leagues of the finance world, leaving RTY with the shit end of the stick.
It's not that untrue of a statement, though it is a bit unfair.
The recent move in RTY has been almost entirely concentrated in regional banks, which you can track through its own ETF KRE. These banks are not the worlds greatest companies. 70% of the holdings in KRE have a < 1 P/B ratio and most are not growing Q/Q. The rate cut narrative is powering a lot of this recent move, but with recent data like PCE coming in-line, some do start to question whether cuts are even necessary, if the economy is doing so well.
As per my 2024 outlook, I do see cuts this year, albeit arriving in September and probably only 2, at most 3.
The market is pricing in 5 cuts of 25PBS through the remainder of 2024 and up to August 2025.
Last week there was even a 22% chance of a 50BPS cut in September, which would be very surprising.
Personally I suspect the narrative going forward for bearish viewpoints is that the small cap index consists of dying companies that do not generate revenue and that a recession is likely - which would impact smalls the most, given these businesses are small in their own size, but collectively are the largest employers in America, and most of those employees also happen to be the lowest income individuals.
So I expect to see a lot of "why would you buy these Zombie companies, they are unprofitable and many are frauds", comments going forward.
Let's see how that ages.
5. You can't use P/E to compare small caps vs large caps. 40% of Small caps don't have an "e".
Adjacent to the last point on unprofitability in small caps - It made me realise that some charts which show that small caps are undervalued vs large caps is actually misleading. These charts use rolling P/E metrics for this data...but 40% of the companies in RTY do not have the "E" in "P/E".
Yeah, it sounds like a joke, but if you think about it...that defeats the whole validity of saying small caps are undervalued vs large caps.
Problem is; How else do you value an index?
How do you value something that doesn't generate any...well..value...? Estimates? Good luck with that. Last week I saw a battery company expecting to hit 400bn in revenue within 5yrs. Their current market cap is 2.5B.
