Just a Fantasy
January 8, 2021·0 comments·In Brief
Small-cap stocks just rallied nearly 5% on the conviction that reflation, low real rates, and Democratic spending will drive returns higher. But the narrative ignores what happens when deficit issuance pushes long yields up and tax proposals begin to materialize. The gap between the story investors are telling themselves and the actual mechanics of what comes next is widening.
- Inflation breakevens are historically volatile and have often retracted sharply after advancing this far. The focus on real yields as justification for valuations misses a simple fact: these rates are low for a reason, and there's limited room for them to move lower. When that becomes apparent, the entire rationale shifts.
- The reflation narrative assumes pent-up demand will persist, but much of that demand was already pulled forward by stimulus and lower rates. GDP recovery has been a function of direct deposits moving into markets, not organic economic expansion. Once that stops, the fuel disappears.
- Small-cap multiples have reached 3 standard deviations above their long-term trend, a level historically preceded by significant pullbacks. The Russell 2000 has tremendous work to do just to grow into these valuations, and that's before considering what happens if rates rise.
- Tax increases are coming regardless of broader political outcomes, and higher long yields are particularly destructive for small caps and biotech. Capital-cost-sensitive companies that make up the bulk of the index will face both higher discount rates and lower profitability. The sectors that led today's rally are the most exposed.
- The speculative bubble in biotech (now 20% of the index through concentrated ETF flows) is propping up the entire index through momentum, not fundamentals. When retail appetite for unprofitable names fades, the entire structure becomes fragile. What happens when the deposits stop flowing and the narrative breaks?
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