Is there a story for small caps?

 

If you look at the Shiller CAPE P/E values, the large-cap market looks expensive. If you look at small-cap stocks excluding the largest Mag 7 stocks, the market seems better positioned. Now that the small-cap risk premium has fallen, some have questioned its validity, but the number suggests a closer look.

If we just look at the 493 SPX stocks outside the Mag & there seems to be more value broadening investor focus. Of course, earnings for the Mag 7 have been higher, which justifies holding these stocks. Additionally, small-cap value and growth have not been rewarded. To hold these smaller-cap names, you truly have to believe that current P/E valuations are a strong predictor of short-term stock performance. Perhaps that is the case over the next five years, but it is a stretch for the next year.

Gold central bank holdings - Saying no to fiat money

The perception of the gold market has changed radically since the Great Financial Crisis (GFC). During the first 10 years of the century, central banks sold gold. Who wants gold when you can have dollars, euros, or yen? Who wants a real asset with no yield when you can have a financial asset with a yield? Who wants a real asset when inflation was under control and less than 2%?  

Now, we know who wants these assets - central banks. These institutions create fiat money, and they don't want it from their peers. Of course, rates were set to zero and, in many cases, moved to negative values during the period of QE. If financial assets can yield negative returns, a hard asset with zero yield looks pretty good. If government debt reaches a new high well beyond GDP, we can suspect it will not be paid with taxes, and governments will have to default on the debt or inflate their economies. The pandemic suggested that governments will go to any lengths to boost the economy with new money. 

The central banks are acting rationally and not telling the public what they really think. Fiat money is out, and hard assets are in. 

JGB rates starting to matter to the rest of the world

Japanese 10-year JGB yields are now 2.34, the highest this century. An end to loose monetary policy, continued loose fiscal policy with the expectation of a tax cut, the "Takaichi Trade", and persistent inflation that is currently at 2.9% means that there is a strong reason to see yields move even higher. The rising JGB rate is having an impact worldwide as money starts to flow back to Japan. Now, it is hard to say this is a complete reversal when real rates are still negative, but the global financial landscape is changing, putting pressure on Treasuries and rates in other countries.

What if we have clarity on Treasury rate direction?

 

We have been strong believers in using volatility, whether the VIX or the MOVE index, as a strong indicator of fear and uncertainty. This is a nonlinear relationship. An increase does not necessarily mean a decline in prices, but once volatility exceeds a threshold, there will be a strong price reaction. Now, we can look at the decline in the MOVE index and infer that the term premium should decline. Since September 2004, short rates have declined by 175 bps, yet long-term yields have increased. This is not what should be expected. Lower volatility should reduce risk and lower yields. This is not happening. 

So what is the reason for the higher, longer-term yields? Well, if volatility measures uncertainty, perhaps there is no uncertainty at all, and bond investors are clear. Bond buyers believe there is greater risk in holding Treasuries, that inflation is rising, and that the safety of dollar Treasuries does not exist. In that case, volatility can be lower, and rates trend higher. Lower volatility and lower uncertainty do not mean clarity is good.