Investment Thesis: There are signs of mounting financial stress as the Fed hikes rates. Now is not the time to invest in small caps.
Due to increasing data showing that active management performs poorly over the long term, investors now use ETFs as the backbone of most portfolios. These funds allow investors to target broad sectors of the market, such as the IWM which tracks the Russell 2000.
The IWM is issued by iShares. Here are the sector’s percentage holdings:
And here are the 10 largest farms:
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The Russell 2000/IWM is made up of small, growth-oriented companies that need rapid economic growth. Unfortunately, the economy is beginning to face headwinds.
Let’s start this discussion with this table:
The above uses the leading, leading and coincident economic indicators methodology developed by Arthur Burns and Geoffrey Moore. Note that financial indicators are beginning to show increased stress and pressure.
Let’s look at the charts in more detail.
BBB yields sit on the key line separating speculative and investment-grade stocks. They start selling when investors believe credit risk is increasing. Yields have risen sharply over the past six months.
The short-term funding market is a little-known and seldom-discussed area of the credit market that only has problems before recessions. The graph above shows that this market is starting to have liquidity problems.
The 10-2 spread is a good predictor of recession. Although the curve did not contract before the last recession, this was a special economic case. At all other times, a yield curve contracts before a recession. The curve is almost there.
Add the following factors:
- The war in Ukraine is once again jeopardizing global supply chains.
- The war also causes commodity price spikes, which adds to inflationary pressure.
- The Russian oil embargo will likely lead to a recession. This is the conclusion of the Dallas Fed in a recent research note:
- “If the bulk of Russian energy exports are off the market for the remainder of 2022, a global economic slowdown seems inevitable,” economists Lutz Kilian and Michael Plante wrote in a Dallas Fed article released Tuesday. “This slowdown could be more prolonged than that of 1991.”
- Not only are Fed rates going up, but several Fed chairs are calling for a 50 basis point hike.
- Powell: Federal Reserve Chairman Jerome Powell said the central bank stands ready to raise interest rates by half a percentage point at its next meeting if necessary, rolling out a more aggressive tone to curb the inflation that he had used a few days earlier.
- Bullard: Asked how quickly the Fed should act, Bullard said “faster is better,” adding that “the 1994 tightening cycle or the removal of the accommodative cycle is probably the best analogy here.”
- Master :
Add all of these factors up, and there are plenty of reasons to move away from small caps and into larger companies.
Finally, here are the tables:
The weekly chart (left) shows that prices have spent most of the past year consolidating sideways. The daily chart (right) shows that prices are below the 200-day EMA and are consolidating below key levels.
We have clearly moved from a small cap orientation to a large cap focus. It’s time to look for greener pastures.