1) Bigger is better?
There is a growing divide between small caps and large cap stocks that became quite pronounced at the end of 2010 (the last time I discussed this divergence was just before the flash crash – see here). As we all know by now equities performed better than most expected in 2010, but the performance across various classes was dramatically different. The Russell 2,000 finished the year higher by 26.3% while the S&P 500 finished the year just 12.9% higher. That’s 2X outperformance!
If recent history serves as a guide that outperformance could be set to end. As a bull market matures large caps have a tendency to outperform. This was the case in 2005-2007. The average bull market lasts over 160% so with 92% of this bull market in the books it’s probably safe to assume that we’re nearing the mature stages. As you can see in figure 1 I’ve charted the large cap to small cap ratio. This chart is interesting because it shows the rather mature years of the prior bull market, the collapse of 2008 and the early phases of the current cycle. At 0.89 we are now at levels lower than the 2005 levels and the depths of the crisis when high beta stocks were tossed out of every window in America.
In addition, from a value perspective there is now a very strong argument in favour of large caps. Although I tend not to like using PE ratios we have to remember that the rest of the voters in this beauty contest do. That said, large caps look increasingly attractive at just 12.72 forward earnings when compared to their bloated small cap counterparts.
This doesn’t mean you should run out and sell your small caps. But it’s likely that the divergence between small caps and large caps will close as the bull market matures. If you’re sceptical of the current rally swapping into a high quality dividend focused large cap portfolio might be a nice compromise between selling outright and trying to pare back risk.
2) Commodities and China can’t both be right.
Speaking of divergences – there is a growing disconnect between China and the commodity complex. As Chinese stocks have gone largely nowhere in recent months the CRB index has continued to surge. As you can see below Chinese stocks have tended to have a very high correlation with commodities. The fundamental story behind this correlation is well known, but as Chinese investors become increasingly concerned about a slow-down the commodity complex is shrugging it off. Could this be a sign that the global economy is complacent about the speed of the recovery?
Figure 4 shows the spot CRB index. It’s clear that this index (which doesn’t include oil – is oil underpriced?) provides us with a dramatically different story of the commodity rally. We’re back to all-time highs. Is this the same bubble that we saw in 2008? I don’t know. All I know is that charts like figure 4 scare the living daylights out of me. If I had to pick a poison I would likely be more inclined to side with the insiders that trade the Shanghai composite as opposed to the gamblers in the commodities pits who are betting on perpetual elevation in commodity prices….
3) Bubbles in the USA?
No one does bubbles like the USA so it would only be appropriate if the next big bubble was formed in the USA. With the Bernanke Put now deeply burned into our souls I am beginning to very seriously consider whether we aren’t merely rehashing the bubbles of old. It’s pretty clear now that the Fed has essentially implemented the same playbook that Alan Greenspan used following LTCM and the Nasdaq bubble. We haven’t really fixed any of the structural problems in the USA. We’ve merely papered them over. And the Bernanke Fed is clearly targeting the equity market as their desired asset to keep “higher than it otherwise would be”. Unfortunately, as mentioned above, they might be causing bubbles in more places than one.
The frightening fact here is that economic recovery appears to be gaining traction. As the deep pessimism subsides euphoria will overwhelm the markets. If Goldman Sachs is correct the equity markets will be at new highs by year-end. You can only imagine the euphoria that will result from such an environment. The Federal Reserve literally printed its way out of a crisis!!! I can already envision Bernanke being crowned something like, oh, “the Maestro”. Yes, that has a nice ring to it. In economic circles it will be as if Mr. Bernanke cured cancer. Except, in this case, we never actually dealt with the cancer. We just shot the patient up with so much percocet that he looks and feels like new.
The environment is almost scarily reminiscent of 2005. A record setting kick of the can hopes to buy us enough time to solve our structural problems. Call me sceptical about actually accomplishing that. So, it looks like the boom bust cycle continues. The Bernanke Put will come back to haunt us all, but for now, I guess it’s time to party like it’s 1999. Enjoy the hangover whenever it occurs because a generation that gets burned three times in 15 years is likely to be pretty fed up with this casino we call Wall Street. Let’s hope it doesn’t unfold that way, however, common sense tells me that using the same playbook in similar environments will likely lead to similar outcomes….
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