Small Cap Stocks vs interest rates

Lehman Brother’s incomprable Jim "Fists of" Fury has some excellent comments on Fed rate hikes, the yield curve and their effect on small cap stocks.  Fury argues that the Fed will most likely continue raising rates and the majority of small cap stock sectors will underperfom.  The one sector that could outperform is energy. However, if the Fed is done after the next rate hike, which Fury thinks is unlikely, small cap stocks should lead the market higher, lead by technology and healthcare sectors. 

"Bullishly, the Fed’s raised rates 8 times in 11 mos, levels history indicates the Fed could be finished tightening w/ the economy strong enough to "land softly."  Bearishly, real Fed Funds rates are low compared to past avgs, creeping wage inflation is appearing w/ 5.1% unemployment, oil is high & the Fed fears oil stoked inflation, housing is rife w/ regional speculation, the yield curve is flattening dangerously & 10-2 year spreads have reached 41 bp, below the "magic 50 bp" level where small-caps typically underperform & experience a non-trivial possibility of losing money. 

So, are the bulls or bears correct?  The determining factor, in our view, is whether the Fed keeps raising rates & the curve inverts.  If the Fed does stop after two more 25 bp tightenings then small-caps can likely rise in the near term & through year-end.  If reversing housing speculation, snuffing out nascent oil inflation, and returning real Fed Funds to average 2% levels to do so is the Fed’s primary concern then owning defensive sectors is best & is consistent with our view to await a better risk-adjusted opportunity."

Heretofore, I have only seen comparisons of today with 1994-1995 hiking period.  Fury likens this period to the 1989 period – that leads to a decidedly more bearish outlook.

"The 1988 to 1989 hiking period is the only other Greenspan-era hiking period to undergo at least eight separate rate hikes (comparable to today’s environment).  In the three months leading up to that eighth hike in 1988 only Technology and Health Care underperformed in a generally down small-cap market similar to current performance leading up to the May 3rd, 2005 (the eighth hike) where Tech, Healthcare underperformed along with Materials and Telecom.Performance after the 1988 eighth hike was broadly positive as it has been since the May 3, 2005 eighth hike.  Financials, Staples and Utilities underperformed in both instances; Technology, Consumer Discretionary and Industrials outperformed. 

Which sectors outperformed between the 9th and 12th tightening in 1989?  Technology performance ranked last in the period between the ninth and final (i.e. 12th) rate hikes of 1988-9 and Energy led with both key sectors influenced by the coming first Gulf War and the early 1990 recession.  Despite leading performance heading into the ninth hike, Technology underperformed sharply in the period following the ninth hike until the tightening was completed with a 12th and final hike.  Energy’s leadership continued throughout the period between the 9th and 12th hikes.  Precursor for 2005?  The technology bulls hope not.

The current small-cap market debate centers over whether to be aggressive and to own cyclical stocks or whether the flattening yield curve and rising oil prices indicate that a slowing economy means the 1989 Energy led market is the more appropriate comparable period for small-caps rather than the 1994-1995 Technology led period.  Our view is that 1994-1995 was the launching pad for a period of rapid economic growth, low interest rates, and a technology/Internet infrastructure build-out/ capital spending boom that is highly unlikely to be repeated in the near term.  1989, therefore, may prove the better comparable for small-caps today."

Fury again points out that the yield curve has a significant effect on how small cap stocks perform –

"The crux of the current bull and bear argument: "An inverted yield curve is not a good thing for small-cap investors NOMINAL or RELATIVE returns."  Only in the late 1970’s and early 1980s as inflation and the oil shock drove interest rates very high and inverted the yield curve did the relationship breakdown.

Said differently, if the Fed continues to raise rates as we expect, in order to soften housing speculation and to avoid repeating the 1970’s inflation fomenting mistake of softening oil price increases with high monetary aggregate growth, the yield curve could invert AND that would be a condition which correlates with difficult small-cap conditions because it would forecast a slowing economy.  This is the factor, in our view, which captures bearish investors’ outlook and worry. 10-year yields minus Fed Funds spreads can be large in either direction and at extreme levels spreads signal high probability forecasts of small-cap relative performance compared to large-caps.  The current era of low interest rates makes nominal extremes less likely in the context of the last roughly forty years’ Fed policy.  But there is precedent in the late 1960s and early 1970s when 10-year to Fed Fund spreads reached -2% despite nominal rates being relatively tame. 

Our point: the yield curve can invert despite the consensus view currently that it will not and its economic effect will be no different than past cycles.  It can be argued that strong corporate balance sheets that are cash rich and whose debt maturities are long term at low rates can withstand an inverted yield curve better than in the past.  But it can also be argued that more consumers hold more debt and more long term variable rate debt whose pricing is short term oriented that will respond less resiliently to rising rates than in the past.

The prior 22-years have experienced only two steeply inverted yield curves when measured by 10-2 year spreads.  Inverted curves occurred in the late 1980’s and late in the 1990’s.  In each case a recession occurred and small-cap investors lost NOMINAL money as well as underperforming large-caps. 

In a majority of years the 10-2 year relationship ranges between 50 and 250 basis points compared to the current 41 basis points.  Small-caps often make money when 10-2 year spreads are greater than 50 basis points(the probability increases when the spread is above 100 basis points) and in general it can be stated "the steeper the yield curve" the better small-caps nominal performance.  Why is a steep yield curve positive for small-caps?  A steep yield curve implies an accelerating economy (or higher future inflation expectations) and stimulative monetary policy that is likely to aid growth.  We state this obvious insight because it is relevant in understanding what message a flat yield curve would communicate and what today’s 41 basis point 10-2 spread implies: the probability of slowing growth and a Fed intent on fighting housing speculation and inflation.  We do NOT mean to indicate that today’s roughly 41 bp spread is a guarantee small-caps will lose money and underperform because it is below the "magic 50 basis point level" where nominal performance can be risky.  But we do mean to communicate that another 100-125 bp would increase that probability importantly and send the message small-caps could lose money.  As we have stated repeatedly, the future six to nine months returns are firmly in Chairman Greenspan & Co’s grasp.

Small-caps have a history of underperforming large-caps when 10-2 year spreads are less than 100 basis points and the current 10-2 year spread is 41 basis points.  The only exception to this "rule" is the 1998 to 2000 period when the Internet Bubble and Y2K conspired to create a highly unusual combination of a tightening Fed that in late 1999 injected large-reserves to insure a Y2K meltdown did not occur."