The Answer to Falling Markets? Buy Small Caps

Small cap investing

If you ever needed more evidence that macro predictions are a guessing game, Morgan Stanley just gave you some.

In 2018, the investment bank said the US yield curve would flatten completely. This means yield for a US two-year bond and a US 30-year bond would be about the same.

What’s actually happening is the opposite. Shorter-term and long-term bond yield are both going up together.

Take a look at the US yield curve today:

MoneyMorning 10-10-18

Source: World Government Bonds

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In fact, what you’re seeing represents multi-year highs. US 30-year bond yields have not reached this level in about four years.

How does this all affect you? Well, what do you think caused our recent market drop? The largest 500 Aussie companies are trading lower because of what’s happening to US bonds.

Let me explain why. Then we’ll discuss an unlikely way you could reduce your overall risk, with theoretically riskier investments.

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$42.5 billion wipe out

First let’s expand on the yield curve explanation. If we peel it away, the yield curve is a collection of interest rate expectations.

Bond yields are affected by bond prices (the lower the price the higher the yield and vice versa). So, if investors believe interest rates will rise in time, the curve will be upwards sloping.

Why would you buy a 30-year bond yield 1–2% if interest rates are going to be 4% long-tem? Most investors will hold out until they see something a bit juicer. And as a result, the price of 30-year bonds decline until the yield is enough.

Typically, this is how the yield curve looks (see below). The longer it takes for a bond to mature, the higher the yield needs to be for investors to buy.

MoneyMorning 10-10-18

Source: Richard P. Slaughter and Associates

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Of course, the opposite can happen too, although it’s not as common. When the yield curve is downwards sloping investors have the expectation that interest rates will be lower over time. Thus, they’re willing to accept a lower yield as compensation.

We saw this happen in 2000, just before US stocks collapsed.

What Morgan Standley failed to predict was a change from a normal to an inverted yield curve, where the curve temporarily becomes flatter.

I’m sure many investors share their view. Global tensions aren’t exactly rosy after all.

Investors are worried about debt levels as interest rates increase. They’re worried about US-China trade tensions escalating. They’re worried about global stocks and whether they can continue to climb.

There’s a lot of worry out there that could drive investors into bonds. This could lift the price of longer maturity bonds, pushing down their yields, making the curve flatter.

It’s a nice theory, but it doesn’t look like it’s going to happen.

That doesn’t mean you’re safe, however.

As the yield curve gets steeper, investors will start to question stock prices. At the moment, stock price are high in part because of low interest rates.

Investors are looking at bond yield of 3% and saying, ‘well, if I can get 5% in stocks I’m happy’. Now what happens when that yield is no longer 3%? What if it’s more like 5%?

Investors are going to demand a whole lot more from stocks. Otherwise why take on the risk of stock investing, if they can get the same returns elsewhere? The easiest, quickest way for stock to offer more potential, say a 7–9% return, is to drop immediately.

It’s why you’ve seen the All Ordinaries (largest 500 companies) come down recently. Investors are reacting to higher bond yields, forcing them to reconsider stock prices. From yesterday’s Australian Financial Review:

Investors wiped $42.5 billion off the Australian share market to send it to a fresh four-month low in a torrid session that saw a number of highly valued growth stocks dumped.

Fresh highs for US 10-year Treasury yields and ongoing tensions between the US and China over trade continued to overshadow markets. Concerns about the health of the global economy were also stirred after the International Monetary Fund nudged down its world economic outlook.

‘…As broad growth concerns mount, investors may be rethinking the case for buying growth stocks following this year’s supersized share price gains. Healthcare and technology stocks were also hit hard in Australia on Tuesday, as CSL fell 4.5 per cent to $188.21 and Cochlear dropped 5.2 per cent to $191.88.

It’s not a hard and fast rule. We’re talking about people after all. But if yields increase further, then you should expect to see Aussie stocks fall lower.

As I said above, there is one way you protect yourself from the fall. Heck, you could even double your money while you’re at it.

Buy small-cap stocks!

Wait, what?!

Should you buy small-caps when the market could decline further? Aren’t small-caps more volatile? Don’t they fall lower when the market falls?

The answer to all three is yes.

In 2007–09, when stocks around the world fell, Aussie small-caps (collectively) fell far more (white line).

MoneyMorning 10-10-18

Source: Bloomberg

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It’s also more common to see small-cap stocks gyrate aggressively, compared to their larger cousins. So why am I saying you should buy small-caps now?

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Firstly, volatility shouldn’t scare you off. In fact, you should see it as opportunity.

Secondly, small-caps probably aren’t as volatile as you might think. Sure they move around collectively. But on an individual basis, some small-caps can be extremely stable. And there are many that can rise even while everything else is falling.

What’s more, if we do see the market fall, it will likely represent big falls in our largest stocks. Unlike the S&P 500 for example, the ASX 200 and the All Ordinaries are extremely concentrated.

When our miners and banks fall, there’s a good chance the ASX 200 and the All Ordinaries will fall with them.

And that’s why the number 0.66 is important. It’s represents the correlation of Aussie small-caps (Small All Ordinaries) to large-caps (All Ordinaries).

Because this is a positive figure, it means small-caps will follow large-caps. But because the number is less than one, it means small-caps will follow large-caps to a lesser extent.

So, if large-caps drop 5% then small-caps (collectively) might only fall 3.3%. (Please take this with a grain of salt. Correlations are changing all the time. Today it’s 0.66, but in 2016 it was closer to 0.9.)

MoneyMorning 10-10-18

Source: Bloomberg

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But most importantly, if you can jump into small-caps with tailwinds, then you don’t need to know if interest rates will rise, or fall, what bond yields are doing or what the correlation is between small-caps and the market.

Individual small-caps, because of their tiny size, can move independently of the market. They can be driven by company-specific news, rather than the big global stories.

Small-caps that are growing sales usually head much, much higher over time. One of our editors, Sam Volkering, believes he’s found a couple of those opportunities with growing sales. Exactly the kind that could defy a falling market. You can find out more here.

Your friend,

Harje Ronngard,
Editor, Money Morning

Harje Ronngard

Harje Ronngard

Harje Ronngard is the lead Editor at Money Morning. With an academic background in finance and investments, Harje knows how simple, yet difficult investing can be. He has worked with a range of assets classes, from futures to equities. But he’s found his niche in equity valuation.

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