The Big Lie

The Russell 2000 has rallied 8.6% since the election hitting all-time highs. This is a powerful move even if it is a knee jerk buying reaction to Trump winning the election. The Russell 2000 had been underperforming before Trump was elected. While the entire market has rallied, the Russell has outperformed since the election as the S&P 500 is up slightly over 1%. There are a few reasons why small caps have done well. Some are rational and others don’t make sense. Overall, I am more bearish on large caps than small caps, but almost all stocks are overvalued in this bubble market.

The first reason why small caps are doing well is because they are deemed to be more risky. In a ‘risk on’ environment buying riskier small caps makes sense. The NASDAQ has fallen about 2% since the election because expensive stocks do badly in a high rate environment. Even though small caps are more risky, they aren’t necessarily expensive. A lot of the decline in the NASDAQ has been caused by Facebook, Amazon, Apple, and Google’s declines. That something to consider when looking at investment style factors. This reason for buying small caps is reliant on the belief we should be in a risk taking environment which I disagree with because the economy is weak.

Another reason small cap stocks are rallying is because Trump promises to cut regulations. One example is Trump plans to revoke some of Dodd-Frank. This is causing the regional banks to skyrocket. The KRE regional bank index is up 15.6% since Trump was elected. Since regulations increase costs and small firms can’t afford large compliance departments, they hurt them more than large firms. Added to this problem is big corporations often help craft regulations with the goal of hurting small firms in order to squash competition. This election change is a positive for small caps. I agree with the market’s reaction for this reason.

A reason large caps are underperforming small caps is because interest rates are rising. In the low rate environment large companies with high debt ratings could do huge bond offerings and use the money to buy back stock. This is an artificial EPS boost which does nothing to help the business in the long run. It creates a temporary bubble in the stock as the stock often gets re-issued during recessions. An example of this is Microsoft doing a $20 billion bond offering and then announcing a $40 billion stock buyback. Microsoft stock is down 4% since was Trump elected because it can’t continue with that practice. This reason for large caps underperforming small caps makes sense. Low interest rates perpetrated the bubble in large cap stocks.

Another reason small cap stocks have done well is because the dollar has been rallying heavily since the election. The dollar index is up 2% and is nearing the price it was at in November 2015. Small caps have most of their earnings in America while large caps have most of their earnings internationally. International earnings will decline when converted into dollar terms. This reason for small caps doing well is illogical because the entire dollar rally makes no sense. I understand that investment in America can help our economy. I understand that the Fed raising rates to fight inflation makes the dollar do better than other countries which are cutting rates. However, the Fed will not win the fight with inflation because the increased investments in America will increase the unmanageable debt to an even more extreme level. When the dollar crashes when investors realize the deficits will be extraordinary, small caps will sell-off.

Another reason for the small cap outperformance is related to the dollar strength. Because small caps have a large portion of sales in America, they are rallying because Trump’s infrastructure stimulus spending will all be spent here. This narrative relies on the concept that Trump’s stimulus package will be a success. The first question is whether it will get through Congress since the GOP is supposed to be against spending. The second question is whether it will be allocated appropriately. I know Trump is a builder, but the government is a poor allocator of resources. The final question is if this will effect long term growth. Most stimulus packages have short term positive effects, so I don’t expect this to be any different. I would not buy small cap stocks because of Trump’s stimulus.

Small cap stocks are also rallying because Trump plans to cut the corporate tax rate. Simplifying the tax code is great for small cap firms who don’t have large budgets to deal with finding the best way to skirt paying taxes they don’t have to.

Conclusion

            There are some reasons why small caps are outperforming large caps which are logical. However, I think all stock styles should be moving lower because Trump’s stimulus will cause rampant inflation which the Fed can’t handle with small rate hikes. This means I prefer shorting large caps to small caps opposed to buying small caps over large caps. Another risk to both small caps and large caps which I haven’t mentioned is the possibility of stricter trade policies. We have to wait and see what the news reports are on what Trump plans to do with Asian trade deals.