Wednesday, January 27, 2016

The Small-Cap Solution To A Recession

Losses across the globe continue to infest the unnerved prospects for global economic growth this year. Stock markets continue their decline into a bear market which is incomparable in length and magnitude to any major periods of 2015. Despite gains earlier this week, more sliding in major market averages today reconfirms the heavily bearish sentiment that plagues traders and their wallets. The Dow Jones Industrial Average, already down 8.5% on the year, fell -222.77 points (-1.38%) to land below the 16,000 point mark. The S&P 500 following large cap stocks fell a total of -1.09% a trend that has continued through the beginning of January. The Russell 2000 small-cap index dropped a little further at -1.50%. Smaller equities have performed worse than their large cap peers since the March of 2014 in a trend that has set spelled danger for new start-ups and IPOs.

Ratio comparison of S&P 500 and Russell 2000
While advancement from the S&P 500 can typically define a solid bullish trend, a helpful confirmation can be the growth of the smaller businesses behind them. Growth in that sector signals healthy growth in wages and jobs as well as plentiful corporate profits and revenue. Long-term weakness from these equities discourages the creation of new businesses because it shows an increasingly stronger barrier to entry. A bearish trend like the one seen above is enough to scare away potential IPOs and even encourage mergers and acquisitions. In 2015, the economy saw its lowest amount of IPOs and the higher amount of M&A activity. A coincidence? I think not.

Left from WSJ; Right from Renaissance Capital
The performance of small cap stocks should be closely related to the trends in both the M&A and IPO markets. As debt becomes more expensive to fund, smaller companies will carry a larger risk premium which is seen by the gap between the two indices mentioned above. Trading in 2016 has pushed this poor performance to a new high which may mean another year of sluggish IPOs. Companies looking to introduce themselves to the public market will be looking for a period where risky bets are less bearish and capital might be more accessible. Similarly, small companies who want to exit the public market where debt and risk premiums have priced their liabilities too high will look for liquidation in the mergers and acquisition market. For that reason, this year could be another four quarters of a corporate shuffling of the cards. Defaults in industries most affected by the commodity rout may cause consolidation by the largest entities with the ability to weather the storm.

The markets for IPOs and mergers and acquisitions are also affected by the price of money, or interest rates, a popular name used by the Federal Reserve. The same monetary organization concluded a two-day meeting in which major stock market losses raised questions over four more rate hikes planned for this year. Even though labor conditions improved in the past year, the FOMC board recognized that "economic growth slowed late last year" although did not acknowledge a spillover into this year. The statement also downgraded "consumer and investment fixed spending," growth to a "moderate rate" from a "solid rate" mentioned in the December statement. A soft shift in position seems to be a blatant disregard for recession-like symptoms; although, a feigned ignorance could be in place to parry a violent stock market response. The FOMC continues to reaffirm its stance on inflation with little changes to its approach there. On the other hand, comments on job gains were highlighted as an upside to the economy. Neglecting to address the real dangers of inflation and failing to review their 2% policy appear, to me, as the biggest blunders in this report. Although, a surrender to the inevitability of fluctuating energy prices might be a subtle nod to its newfound power on the trading floor. For these reasons, the Fed Funds rate was held at the previous range of 0.25%-0.50% decided in December with a cautious pair of eyes on new data for direction come the next meeting. Futures traders are already placing their bets on the downtrend with the Fed Funds futures price giving a 25% chance of a quarter-point increase in March.

Even though monetary conditions remained easier than what they could have been, the Fed's uncertain tone alienated investors and convoluted the organization's plan for the next couple meetings. Global stocks traded flat in response with the Global Dow up only 0.32 (0.01&). Asian stocks are mixed as they open with Japan and China leading with losses 0f -0.82% and -0.29%. European stocks also traded mixed with slight aggregate gain shown by  a 0.37% increase in the Stoxx Euro 50. The monetary institutions in these markets have already committed to increasing their expansive policy in the face of the global losses. The uncoordinated monetary solution has done nothing but augment the amount of discomfort in the minds of investors which rely heavily on discounting the future. An unclear future can result in capital leaking to safer segments of the market (bonds) as companies deal with shrinking profits. This is the conundrum our financial world faces today, and it can be connected to the performance of small businesses and the IPO and M&A markets. Recessions occur when that one business owner or investor is unwilling to take that risk because of the unsafe business conditions, a feeling that is extremely contagious. The United States, the euro zone, and the major Asian economies cannot emerge from their rut until their individual businessmen make that decision to trust their country's economic health.

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