The Notorious S.M.A.L.L.

Steady as She Goes: The market shook off slightly higher-than-expected inflation data this month. Earnings reports have been supportive, with Taiwan Semiconductor supporting tech stocks. Should the rest of earnings go well, 6000 on the S&P 500 is within reach. The market, much like a big ocean liner, is chugging along, and small impediments (slightly imperfect reports) appear to be just that. However, there are icebergs that could be of concern; inflation reaccelerating or dropping precipitously, misses in the AI and technology spaces, default rates spiking in the consumer or real estate space, and the eternal favorite, the unexpected. Smooth sailing for now though.

The Call to Small

There have been scores of strategists and countless portfolios capsized by overweighting small caps through the years. However, analysts forecast that by the second half of 2025 small cap earnings growth will rebound, potentially exceeding large cap earnings growth. It is reasonable to believe that—if that forecast is correct—capital will finally start moving into small caps before then. The problem is that the only current argument for small cap outperformance is a rebound trade based on a wide valuation gap. Using median Price to Earnings ratios, small caps are cheap, ranking in their 30^th percentile of valuation historically, while the equivalent S&P 500 multiple ranks above its 90^th percentile.

The question is how to time this because you want to ease in, not pile in.

Given that this trade is a long beta and long cyclical strategy, we need to identify a cyclical re-acceleration in the economy. We will help identify inflection points, such as when the Sales, Earnings, and Inventory categories in the National Federation of Independent Business Survey turn up. That should signal the next leg up in economic activity, coinciding with small cap firms attaining pricing power, a factor that is essential for their outperformance.

Avoid being too early. It is optimal to wait for an economic downturn to take advantage of small caps’ high operating leverage, which historically fuels outperformance thanks to margin expansion. With Pave Pro, you can benchmark the risk and return of the Russell 2000 without being exposed to small caps immediately. This is achieved by loading in a Buy List of your choosing that spans the full scale of capitalization, from small all the way up through mega cap tech stocks. It is only when the Pave Pro factor models attractively rank small caps that your portfolio will be populated with small caps and not before. This valuable feature of Pave Pro prevents the problem of anticipating a rotation before the rotation occurs.

Talking Crude

Something odd happened in Saudi Arabia. Iran’s Foreign Minister Abbas Araghchi met with Crown Prince bin Salman. This does not mean everything is al-khūkh and cream (peaches in Arabic) between the two countries, but it does lower the risk premium on crude oil. If the Saudis are pushing away from Israel and leaning toward Iran, an attack on Iran appears less likely. Araghchi also met this month with several of his counterparts across the Middle East, and the discussions show the potential for more regional cooperation.

Oil seasonals peaked recently and are bearish into late December. WTI crude oil may be vulnerable to spending an extended amount of time below $70, a rare occurrence over the past three years. With the balance sheets of U.S. independent producers in good shape, a price drop to $60 may not see any of them forced to curtail production. Therefore, production may not contract as price falls. Crude tends to bottom in February, although a Trump win could see crude oil hit a selling climax as early as next month.

Debt Silence

The country continues to ignore the fiscal elephant in the room. At the end of the second quarter, the total public federal debt totaled $34.80 trillion. Since then, the debt grew by almost $1 trillion by October 15 to $35.75 trillion. The interest payment on the federal government’s debt is now over $1 trillion, and that interest bill has grown by over 20% compared to last year. That is a shockingly high rate of increase, only matched briefly right before the recessions of 1960 and 1981.

The hope is for the Federal Reserve to unravel the 500 basis points of rate hikes to drop the cost of servicing the debt. Unfortunately, the neutral rate, or the equilibrium funds rate that does not cause inflation or employment to fluctuate, is forecast by the Federal Open Market Committee (FOMC) to be 3%. With the target rate now at 4 ¾% - 5%, at best, they will have cut interest rates by half the amount of their original rate hike when they reach a neutral monetary stance. Assuming the Fed stops there, the only way for the market to reduce long-term rates further would be if there is a sharp economic decline. However, a growth contraction will push the amount of debt higher because the government will respond with increased fiscal spending to help counter recessionary forces.

Conversely, if the economy expands, inflation should rise, especially as globalization continues to contract. Higher inflation translates into increased rates on Treasury securities. In that case, government interest payments rise even if federal revenues increase and cause the deficit to shrink. The only prudent action is a gradual reduction in the deficit that avoids a recession. With tariffs increasing regardless of which party wins (and the downward pressure on GDP that will occur from the added tariff burden), the chances of avoiding an economic downdraft while cutting federal spending are low.

What to Look for This Week

1. Monday, October 21 at 1:00 p.m. E.D.T. Minneapolis Fed President Neel Kashkari speaks. One week ago, he said that he promotes gradual rate cuts even though a senior research economist under Kashkari finished a study explaining why the labor market is softer. We will see if Kashkari argues for more aggressive cuts or maintains his view.

2. Tuesday, October 22 at 10:00 a.m. E.D.T. Richmond Fed Manufacturing Survey of Manufacturing Activity for October is published. This regional index is of interest to us because September came in at -19, and there have only been two months during the height of the pandemic that have been lower than that number over the nine years of the survey.  

3. Wednesday, October 23 at 2:00 p.m. E.D.T., the Federal Reserve’s Beige Book is released for their November 6-7 rate setting meeting . It is compiled by the 12 regional Federal Reserve Banks and is the result of polling various businesses across the country about economic conditions. The August Beige Book reported that the number of regions reporting declining activity rose from five to nine. We will see if the September rate cut had a positive effect.