Lehman Bros.' Jim Furey on Smallcap Strategy

Lehman Brother's incomparable Jim "Fists of" Furey remains neutral to negative on the Russell 2000 (IWM). He feels that the Fed hasn't signaled that it will stop raising rates and that investors are not well positioned for the likelihood that rates can continue to go higher. From yesterday morning's Small Cap Strategy report:

Two things stand out about Friday's price action. One, the "Fed will pause in August and the economy is healthy enough to rally the Russell 2000" trade is crowded. Two, 0.4% sequential wage inflation is the most important number in Friday's Labor Report, in our view, as wage inflation is accelerating given Friday's figure annualizes to over 5% and compares to a current YoY rate just under 4%. We believe the Fed will discuss wage inflation in the context of July's rising unemployment rate, though still down 20 bps from a year ago, placed with an economy arguably running above its sustainable growth rate given capacity utilization over 82% leading us to conclude more tightening will occur before 2006 is ended.

Russell 2000 technicals: major downtrend intact, counter trend rally fails at major trend’s upper edge.

Crowded Fed Rally Trade, Accelerating Wage Inflation, and a R2000 Close Below its 50 & 200 DMA. Friday's trading began with a celebratory gap-open rally catalyzed by a weak labor market report promoting the thesis that the Fed would almost certainly pause in August while the economy was still strong enough to continue growing '07 earnings at an attractive rate given today’s small-cap valuation. The R2000 quickly bullishly eclipsed both its 701.26 50 DMA (based upon Friday’s close) and its 710.54 200 DMA, peaking at 716.05 before falling and failing to remain above important 711 resistance and its 200 DMA while barely maintaining above its 50 DMA. The market’s bearish mid-day reversal reflects, in our view, a crowded "Fed pause while economy still healthy" rally trade. Simply stated, by the afternoon Friday there was no fresh buying power. But there was plenty of doubt along two lines: 1) is the Fed done raising rates given the sequential 0.4% wage inflation, and 2) would the economy be strong when the Fed was finally done raising rates, August pause or not. By 3:00PM doubts fueled losses where the R2 had fallen 22 points from its peak and touched as low as 694.

We were surprised that the Fed rally trade was as crowded as it appeared Friday and continue to believe that the Fed will not end its tightening campaign until inflation's nascent threat is erased. The Fed may pause in August but the Fed is not done tightening, in our view, because the inflation genie is out of its bottle and will require more tightening to be put back in, which will come at the cost of economic damage. The Fed has waited too long to slow the US economy and inflation psychology is now altered, in our view. Strong global growth, China’s material consumption, global excess savings and higher oil prices have not helped the Fed’s inflation fight. In that vein, Friday’s sequential 0.4% wage gain brings YoY wage gains to almost 4%, troublesome to the Fed, and accelerating at a 5% plus annualized rate. Oil prices move higher, not lower and China shows no sign of slowing, in our view.

Bernanke has stated that a slowing economy will ease inflationary pressures. LEH's Chief Economist, Ethan Harris has stated that Bernanke's thesis that a slowing economy slows inflationary pressures is open to much academic debate. Psychology, capacity utilization, and special factors, e.g. oil prices, all can play an important role determining inflation's rate. These factors are all working against the Fed’s easy battle against inflation and are why we believe the Fed will have to continue to raise rates further even if they pause in August.

Before this year is out, a Wall of Worry will be built upon stagflation that will be tradable, in our view. Friday’s price action was an important foundational brick in the Wall, in our view. The small-cap market is not yet ready to meaningfully rally. There are too many believers in the “Fed pause without economic damage” thesis, in our view.

I'm siding with Furey's view right now. I believe the fundamentals and monetary trends leave a lot to be desired. In addition, valuations for small cap stocks are far from cheap, unlike their large cap counter parts.

And while the sentiment appears negative, I think a lot of professional money managers are still "hoping" rather than "knowing" that the Fed is nearing the end of its tightening cycle. If the Fed does not give a clear indication that it is done raising rates, I believe another down leg could ensue.

IWM 1-yr chart: