The “little” correction that the bulls welcomed a week ago as a much needed break has finally got some teeth.
For the first time in quite a while, there is some definite fear out there. Dips are no longer buying opportunities, but instead the start of small waves of selling. The rallies that do occur are met with heavy over head resistance.
I stick by my theory that we are not going to see a return to the highs anytime soon. There are simply too many offside longs that have pushed their luck too far. The real question is whether we can drift downwards/sideways for a couple of months to correct this overbought condition, or whether we are prone to a much nastier decline. I am not sure about that yet. A lot will depend on the upcoming data and the Fed’s response.
Small vs. Large
Lately there has been increased chatter about the small cap sell off. For the past month small caps have been trading “heavy.” They peaked at the end of June and have been sliding to new lows every week since then.
Some analysts such as the Bank Credit Analyst (BCA) have speculated that the reason for this sell off is rising wage pressure.
In the interim, the message is that small cap labor expenses are likely to be far more punitive than wage costs for large businesses. This is confirmed by the sharp rise in the household employment survey relative to the establish- ment survey this year. The former includes smaller companies and the self-employed, and when it rises faster than the payroll survey it is a signal that wage pressures are building among smaller firms. Thus, small cap profit margin pressure will become more acute earlier than it will for large caps.
Although I respect BCA, I am going to have to differ. I don’t doubt there might be a part of their theory that is correct, but BCA goes on to highlight that this small cap underperformance is a global phenomenon.
There is no way that the Euro area is experiencing wage pressure inflation. Their economy is in the toilet and unemployment is stubbornly high. Even the emerging market economies are far from the sort of overheating growth that would result in wage pressures causing small caps to under perform.
Why then have small caps being so weak? To answer that question we need to flip it upside down. The real question is to ask is why have large caps being so strong?
Once you get the question right, the answer is quite easy. Large caps have been strong because they are most able to take advantage of the easy credit. They are the companies that are able to float billion dollar bond issues and use the proceeds for stock buybacks. Small caps simply don’t have access to that sort of credit.
The small cap market rolled over earlier because there was not the massive buy back support. In my mind, the small cap market is a more “pure” indicator of where stocks want to go right now.
Of course it didn’t help that the hedge funds had been leaning heavily short the small caps. A week or so ago I wrote about how I was avoiding being short the small caps because of this positioning. It just goes to show that a stopped clock is right twice a day as I managed to get that one right.
I am not sure whether the recent small cap relative outperformance is the result of these shorts covering, or whether it is a signal that the sell off is going to be contained. For now I am assuming the former, but I will be watching the relative small cap/large cap performance for clues about future broad stock market moves.
When I do get bullish…
When I do get bullish, I know what I am going to buy. Yesterday I wrote about the influx of capital into Hong Kong. I am none too quick and sometimes it takes me longer than it should to put the puzzle pieces together.
If the Hong Kong Central Bank is forced to sell Hong Kong Dollars to maintain the peg, the monetary base expands. We went over all of this yesterday. But I mistakenly didn’t take the next step.
Expanding the monetary base is like engaging in QE in terms of its effect on risk assets. Have a look at this chart of the Hong Kong Dollar, the monetary base and the Hong Kong stock ETF.
When the base expands, one of the direct beneficiaries is the Hong Kong stock market. If you believe that capital will continue to flow into Hong Kong as the result of the sanctions against Russia, then the Hong Kong stock market should be a big winner.
For now I am just watching it, but when I do get ready to buy stocks, the Hong Kong ETF (EWH US Equity) will be at the top of my list.
Wheat – trying to make a bottom?
Like a mope I have been riding the massive downdraft in the grains. It is a long term position, but I recently dramatically increased my position as a result of a tactical trading view.
So far this call looks like it just might work. The price action in wheat has been especially encouraging.
And what I like best is the fact the hedge fund speculative positions have increased their short bets to record levels!
I hate being on the same side of trades as the hedge funds, so the fact that they are shorting wheat down here as it bases tempts me to buy even more!