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Small Business Sentiment At 20-Year Low

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Is extreme pessimism a buy signal?

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Pessimism about our economic prospects is dire.

Domestic recessions tend to hurt small businesses the most. They don't derive much revenue internationally, so struggling local economies force them to cease hiring and button down purchasing activity. According to the Bureau of Labor Statistics, small businesses (under 50 employees) accounted for 36% of all net job gains from 1990 - 2005, so small business are not inconsequential by any stretch of the imagination.

A representative association, the National Federation of Independent Business, or NFIB, polls their small business members monthly and asks about their economic outlook. The latest release was a doozy.

According to the NFIB, their members have never been more pessimistic. Its monthly index of small business optimism just dropped to the lowest level in the 20+ years the NFIB has been conducting its survey, as shown in the chart below:

Click to enlarge image

Is this a good contrary indicator for the stock market? Let's look at the returns in the small-capitalization Russell 2000 when small businesses showed their 20 most-optimistic readings versus their 20 most-pessimistic readings:

Russell 2000 Returns When Small Businesses

Were At Their Most Optimistic

1 Month

Later

3 Months

Later

6 Months

Later

12 Months

Later

Average Return

+1.7%

+0.5%

+3.6%

+6.7%

% Positive

70%

55%

70%

80%

The returns following months of very optimistic readings were not that bad - mostly positive, but weaker than random.

Now let's look at how small caps performed after very pessimistic readings:

Russell 2000 Returns When Small Businesses

Were At Their Most Pessimistic

1 Month

Later

3 Months

Later

6 Months

Later

12 Months

Later

Average Return

+2.0%

+8.9%

+18.1%

+24.8%

% Positive

70%

83%

88%

94%

There's quite a difference here. The three-month forward return in the Russell 2000 was nearly +9%, and it was rare to see a negative return. The longer out we looked, the more positive the readings became, both in terms of consistency and magnitude.

Small cap stocks were in a major bull market during the majority of this study period, so it stands to reason that buying during times of periodic pessimism would create good returns going forward. Perhaps we're in for a multi-year bear market and these historical rules will not apply.

But perhaps not. Maybe the idea of a recession has been so firmly baked into our national consciousness that the worst of the selling pressure has already been seen. The fact that surveys are showing multi-decade low levels of optimism are a sign that could be the case, and we have to consider the possibility.
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No positions in stocks mentioned.

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