The SP500 index (C fund) has remained in the top half of its primary price channel through the normally weak summer months. Typically we see a pullback late in the unfavorable season (August – October) to somewhere near its high in late Spring. So far, the large companies within the SP500 have been steadily marching higher.
The next two weeks are historically weak and we could see one more pullback prior to the historically strong end-of-year performance.
What I have observed during the present market cycle is when the central banks open the monetary spigots, stocks continue to trend higher even in the normally flat summer/fall time frame.
The monetary spigots remain wide open
Today, even with the Fed raising rates the US is excessively loose in terms of monetary conditions – interest rates are below the rate of inflation. The Bank of Japan is monetizing their debt and slowly monetizing their stock market while the ECB is now buying corporate bonds with money created out of thin air.
As the markets pass the extreme valuation levels achieved in 1929 and 2000, we have the central banks to thank. Global monetary policy has never been looser than the last two years extending this bull market.
The financial markets are detached from the economy and corporate profits. When bad economic data sends the stock market up and good economic data sends the market down, we have all the evidence we need to know we are in another financial bubble. The markets are acting on expectations of monetary policy not fundamentals.
The volatile small cap funds
The TSP fund prices were set in 2003 at $10 per share. The TSP S fund (tracks all the US non-sp500 companies) has outperformed since inception. But does that mean small caps always outperform?
If we look back about 30 years, it is a tie. The popularity of SP500 index funds allowed it to more fully participate in the 2000 stock bubble. Small caps closely matched the large caps during the housing bubble. With the current QE bubble, small caps have slightly outperformed large caps since the bottom of the financial crisis. They also initially outperformed during the QE bubble extension that started on 11 February 2016.
A closer look shows the TSP C fund (a SP500 index fund) has out-performed the TSP S (non-sp500 index) fund since 2011. After deep corrections the small cap fund out-perform simply because the small caps tend to lose more during the corrections.
I see two factors that have driven the difference in the relative performance of the small cap fund to the large cap SP500 fund this cycle.
The first is the long established tendency of the small caps to out-perform during the favorable season for equities and under-perform during the unfavorable season. I often point out the small cap funds are the best candidates for seasonal strategies.
The second factor has been the timing of the liquidity operations of the central banks since the financial crisis. The red lines show the rallies in the VXF ETF that tracks the same small cap index as the TSP S fund. The rallies correlate highly to each QE or other monetary operation. The orange lines highlight when the other central banks picked up the QE largeness.
The black line plots the ratio of the small cap fund to the large cap SP500 fund. The small caps significantly out-performed the large caps during the RISK-ON environment created by quantitative easing (QE) and other liquidity operations. We also see the small caps pulled back further when they were no longer back-stopped by central bank QE.
The boxes show when the actual operation was in effect. It does not show when the central banks started talking about the programs which encouraged front-running by speculators. The end date was also known and the markets often faded the end date.
While small caps initially out-performed the current rally that started on 11 February after the Janet Yellen made several unscheduled phone calls to other central banks, large caps have out-performed since late December 2016 (declining black plot).
The canary in the coal mine
When speculators feel the central banks are back-stopping the markets, they move into the more volatile and higher yielding securities – small cap stocks and low quality high-yield bonds.
When they believe central banks are going to pull-back from buying or a monetary program is close to ending the most risk-sensitive securities provide early warning. When these securities pullback significantly, they provide early indications of a broader market sell-off.
Simply put, when perceived danger approaches the most risk-sensitive speculators start heading toward the exits first. With the Fed raising interest rates and starting to reduce their balance sheet (reverse QE) monitoring risk-sensitive investors has never been more important.
We monitor these securities and investors daily.
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