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Just a Fantasy

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Is this the real life?
Is this just fantasy?
Caught in a landslide
No escape from reality
Open your eyes
Look up to the skies and see
I’m just a poor boy, I need no sympathy
Because I’m easy come, easy go
A little high, little low
Anyway the wind blows, doesn’t really matter to me, to me

Queen – My Secret Fantasy


  • Tactical Long. On November 24th in The Merger Is Complete, I wrote: “Buy the bull*&-t for a trade into Christmas on fund flows, but don’t buy into the nonsense narratives permanently. [1]I reiterated this tactically bullish position after Christmas in the Bloomberg What Goes Up podcast with Michael Meyer and Sarah Ponczek (stating it would persist into January).
    • Close It Out. It’s now time to close out that long equities trade, especially in small caps, which in any rational universe are wildly overvalued and technically hyperextended; the small cap reversion to reality should occur regardless of whether the Senate swings Democrat (albeit this would be a more bearish outcome despite the reflation narrative to the contrary). Today’s almost 5% rally in small caps could only happen in a fantasy world of avatars and magical thinking. [2]
  • Real Rates. The rationale that recent new lows in real rates justify yet higher equity prices is misplaced because breakevens are volatile and, more importantly, inflation expectations are coming from the nuances of pandemic impacts and stimulus rather than from organic growth expectations.
  • Deficits. Upward pressure on long yields from deficit issuance will surely continue. Even with the Fed sitting on long yields with QE, it will have much work to do to sop up new issuance. This situation could worsen should the Senate swing to the Democrats (i.e. – more Treasury issuance to fund fiscal largesse). I circle back to the two risks I’ve articulated from months: higher taxes and higher long yields. The latter are particularly troublesome for tech and small caps.
  • Taxes and Yields versus Direct Deposits. Three words come to mind on a Democratic win in both Senate races: taxes, taxes, taxes. Over the next four years, under the Biden administration and even in a split Senate, taxes will certainly go no lower, especially when considering proposals like Senator Wyden’s 2019 proposed tax on unrealized gains in investment assets at the same rates as other income. [3]  Does this sound reflationary? Perhaps its reflationary for equities if money supply from direct deposits continues to find its way into the stock market, but it won’t be reflationary for corporate profits or disposable income for those with the highest propensity to spend. [4]
    • Risk to View. The biggest risk to this view is that new stimulus (supplementary direct deposits) will continue to fuel the speculative bubble in equities despite the substantial economic tradeoffs in the form of higher taxes and rising yields and without regard for hyperextended valuations. It’s certainly a difficult set of vector forces to assess.


The idea that low yields – most recently the focus of the narrative has shifted to low real yields – is somehow giving market participants’ confidence that equities will continue their ascent. There are a number of objections to this assessment. First, Figure 1 shows that the breakeven 10-year is relatively volatile. The U.S. breakeven 10-year is the difference between nominal 10-year yields and 10-year TIPS. Simply because the breakeven 10-year sits above 2% does not mean it will remain there. Second, it’s necessary to ask ‘why’ it’s there. Is it really productivity growth that will sustainably drive ’good’ inflation? That’s unlikely. Recent wage inflation has been a function of a change in employment mix and goods inflation a function of supply shortages.

The GDP recovery has largely been a function of stimulus. Market participants seem to be betting on massive pent-up demand, but notwithstanding a higher savings rate, much of that that demand may have already been pulled forward by lower rates and massive fiscal stimulus. In fact, given the historical volatility in breakevens and given the Fed’s inability to do anything to achieve its inflation target, real rates are more likely to rise than fall (i.e. – breakevens will fall). If anything, Figure 1 shows that this is just about as good as it gets for breakevens, which almost always retrace after such an advance. [5] Figure 2 decomposes nominal yields, real yields and the breakeven rate. Nominal and real yields have tended to move in lockstep, so the focus on real yields, while important, adds something less than perceived.

While it has served investors well for over 35 years, the old adage ‘don’t fight the Fed’ is on its last legs. Bill Dudley simplified it relatively well: “The stimulus provided by lower interest rates inevitably wears off. Cutting interest rates boosts the economy by bringing future activity into the present: Easy money encourages people to buy houses and appliances now rather than later. But when the future arrives, that activity is missing. The only way to keep things going is to lower interest rates further — until, that is, they hit their lower bound, which in the U.S. is zero.” [6] (By Bill’s logic, this is yet another reason why inflation isn’t coming.) [7] The incremental benefit from lower rates (whether nominal or real) is extremely limited. Indeed, even if reflation were in the cards, higher long yields would likely lead to an equity market reaction similar to late-2018. Risk-assets, when priced to perfection, tend to be quite sensitive to higher yields. Lastly, because cash flows have been so weak, the probability that the credit cycle is over is low; S&P Global Ratings seems to agree. Its 2021 speculative grade default forecast is about 9%. This level of defaults should impact small caps most.

Figure 3 above shows that the Russell 2000 has tremendous work to do to grow into its elevated multiples, which are unjustified by lower rates. Rates are this low for a reason. I’ve made this argument on many previous occasions, and (other than Mr. Dudley’s quote) I will spare readers of it yet again. What this Figure shows is that elevated multiples often precede Russell 2000 selloffs. It is sometimes true that index multiple expansion precedes rallies, as company earnings recover and grow into multiples, but this interpretation would ignore the fragile state of Russell earnings prior to the pandemic. For all companies (including those without earnings) Russell earnings were down about 15% year-over-year for 2019. Importantly, with 10-year yields creeping up on more deficit spending and the Treasury issuance it requires, smaller capital-cost sensitive companies (like those in the Russell) are increasingly at risk as real rates rise on lower-than-expected inflation or on higher nominal yields (on Treasury supply). [8]

From a ‘technical’ standpoint, Figure 4 shows the Russell 2000 overlayed with a ‘power’ regression. The regression prediction is banded by +/- 1-SD in yellow and 2-SD in red. The ‘innovation’ here is the choice of power regression, which fits the price trend extremely well and takes into account an accelerating trend that a linear regression would not. What it shows is that the 2-SD band (red) above the price trend (dotted blue) has served as resistance (as one would expect given the confidence interval). The Russell pulled back significantly at that 2-SD level in 2000, 2007, 2014, late 2015, and again in January 2020. It failed to do so in late 2018 as a rotation narrative took over. Currently, it has also failed to serve as meaningful ‘resistance’ as retail mania is driving a similar rotation on an even more hollow rotation and reflation narrative. However, the Russell did pull back at just over 3-SD above trend in 2018, and that’s where it is again right now. So, even if the price trend is accelerating (changing the regression prediction and making it less accurate), there’s lots of ‘cushion’ to this assessment. Lastly, today’s rally pushes the Russell 2000 into long term uptrend resistance, which began just after the 2009 low, as shown in Figure 5. [9]

There are arguments to be made that the one’s expectations for the performance of the Russell 2000 should change, as its composition has now changed somewhat (over 20% healthcare). What ‘healthcare’ really means is small cap biotech, which has been a darling of the retail crowd as many look to profit on the next Moderna. On the other hand, this might be considered yet another reason to dislike the Russell 2000, as many of these names are highly speculative (i.e. – unprofitable) and have contributed to the overbought and overvalued condition of the index. The bulk of the index still consists of consumer discretionary (~11%), broad financials (18%), materials and industrials (~19%), and real estate (7%). All of these sectors rallied on January 6th with financials and materials outpacing most other sectors. If anything, while the speculative bubble in 1999 was mostly in communications technology, it may now be in biotech, which is dragging along other sectors through ETF buying. The Russell has of late become the posterchild for speculation in biotech – along with the new ETFs ARKK and ARKG.


Todays 4%+ rally in small caps likely isn’t sustainable. They are simply priced to a fantasy world that is unlikely to ever exist. It wouldn’t be the first-time small caps experienced manic highs (or lows). The reflation narrative on a Democratic sweep (more profligate stimulus) ignores the impact of higher taxes and the potential for higher long-yields. Sure, it’s tough to ‘get things done’ in Washington, but you can bet taxation will be the first order of business should a blue wave sweep through Washington. Even without that wave, the reflation narrative makes little sense. Much of the narrative is based on higher breakevens, which are often not predictive of future inflation. This is particularly important to point out on a day when the reflation narrative is being plastered everywhere.

Small caps, in particular, are subject to more extreme swings in sentiment than even technology companies, many of which are now mature cash flow generators. Certainly, the money supply has exploded on fiscal stimulus, which has increased deposits. As I’ve pointed out, those deposits – coupled with easy access to markets through mobile-based trading apps – have found their way directly into equity markets, and especially into the most speculative stocks (i.e. – small caps). As the pandemic begins to abate and money supply begins to contract, despite a modest but determined economic recovery, small caps will once again fall out of favor. Today’s strength is an opportunity to lighten small cap exposures or hedge aggressively versus implicit or explicit long small- cap exposures.


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[1] Jeremy Grantham and I remain on the same page with GMO reiterating its bubble warning yesterday. After becoming bullish in March and cautious in late June, I felt the same pain into November.

[2] As of this writing, the Ossoff-Perdue race looks too close to call.

[3] https://www.wsj.com/articles/top-democrat-proposes-annual-tax-on-unrealized-capital-gains-11554217383

[4] https://www.yodlee.com/many-americans-used-part-their-coronavirus-stimulus-check-trade-stocks

[5] As I’ve noted, for many companies, ‘price’ will be difficult to achieve (other than in areas where there are pandemic-related supply disruptions) because of overcapacity. According to Bloomberg, almost 600 corporations of 3,000 of the country’s largest publicly-traded companies no longer have EBIT/Interest > 1. The same companies added almost $1 trillion of debt to their balance sheets since the pandemic began, bringing total obligations to $1.36 trillion. As the article suggests: “But in helping hundreds of ailing companies gain virtually unfettered access to credit markets, policy makers may inadvertently be directing the flow of capital to unproductive firms, depressing employment and growth for years to come.”

[6] https://www.bloomberg.com/opinion/articles/2020-10-28/the-federal-reserve-is-really-running-out-of-firepower

[7] Here’s a caveat. His is an incomplete description of how monetary policy works for at least two reasons. First, it fails to convey the intertemporal impact of monetary policy on investment. Second, it fails to appreciate the offsetting impact on the income channel. That is, the benefit to consumers or companies to consume or make capital expenditures because of lower rates is offset (at least in part) by the loss of income to savers. The basic macroeconomic equality that investment is equal to the sum of foreign and domestic savings suggests that a reduction on one ought to be offset by the other. The argument becomes a qualitative one that the income benefit to savers has a lower multiplier than the benefit to consumers or companies. Indeed, some might argue that this means monetary policy is itself no effective at stimulating ‘real’ economic activity, and fiscal policy is the only impactful alternative.

[8] The steeper yield curve won’t be good enough to pull small cap banks (~13% of Russell 2000) out of their malaise. Credit losses for regionals and the impact of higher rates on loan demand will more than offset the positive impact on NIMs.

[9] Unfortunately, implied volatility remains elevated, so it makes sense to sell some options to cheapen up any synthetically constructed short trade on the Russell 2000. This often makes the return profile a bit more linear, but one can still fashion something interesting. The IWM is 1/10 the Russell 2000 index with very little tracking error. One possible way to express the sentiment I articulate would be an IWM ‘put spread collar.’

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