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Small Caps About to Get Tapered?


While the media continues to talk about bonds, it might be time to look at this market segment instead.

Most projects start out slowly -- and then sort of taper off.
--Norman Ralph Augustine

The long awaited (and delayed) jobs report continues to confirm the theme that stocks and bonds have priced in reflation that simply does not exist. Demand-pull inflation fear is in no way shape or form accelerating as of yet, and cost-push commodity inflation remains relatively muted. The bond market, especially on the long duration side, is beginning to realize this with yields dropping. Some argue this means the Fed will hold off on tapering for some time to come, and that in turn is bullish for stocks. The problem with this thinking is that at some point the market must question whether QE is helping or hurting the economy, and ultimately fundamentals, which over the longer term do matter. QE effectiveness, if questioned, is the thing few are focused on (yet).

The market may be in the midst of a "Great Re-Pricing" now. The models my firm uses for managing our mutual fund and separate accounts recently positioned into bonds as yields drop to reflect the reality of faux reflation. Emerging markets (NYSEARCA:EEM) are also a part of this re-pricing as strength persists on the realization that no crisis occurred to justify such a big spread against the S&P 500 (INDEXSP:.INX). Small-cap stocks relative to large-caps may be the next relationship to synch, not to beta, but rather reality. Often times, small-cap stocks are considered a true "risk-on" trade within US equities. Because they are less sensitive to global growth expectations and move more on domestic expectations, a pure play way of gauging investor sentiment on a country is through smaller companies.

Small caps have had one helluva run in 2013, "discounting" significant growth. Jobs data continues to confirm that this simply is not occurring, and the belief is getting long in the tooth. Take a look below at the price ratio of the Russell 2000 ETF (NYSEARCA:IWM) relative to the S&P 500 (NYSEARCA:SPY). As a reminder, a rising price ratio means the numerator/IWM is outperforming (up more/down less) the denominator/SPY.

Small caps began strongly outperforming large cap names starting in May, and seem to have peaked out at the very start of October. Note that the ratio is not only extended, but at levels that held prior to the Summer crash of 2011. While everyone is staring at absolute price movement, small caps on the far right may have peaked relative to large caps. Of course this does not mean a collapse has to come, but this could be a sign of deterioration building within equities, especially given the way bonds are acting.

While the media continues to talk about bond tapering, maybe its small caps in the US that are about to get tapered....

Twitter: @pensionpartners
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No positions in stocks mentioned.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

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