Small Cap U.S. Equities: A Blast from the Past

Macro Man is back on the desk, safely re-attired in standard-issue hedge fund costume: sport coat, jeans, and collared shirt. He's never been a fan of wearing a suit and tie, but in the current populist backlash against bankers and hedge funds the idea of slipping a knotted length around his neck is distinctly uncomfortable!

Today Macro Man would like to address a couple of old stand-bys and one new development. Leading off are his old mates from China, where the market is all aswirl with talk that the authorities will soon countenance an adjustment in the exchange rate. In its recent quarterly report, the PBOC announced that it intends to "improve the exchange rate mechanism is a proactive, controlled, and gradual manner..."

ZZZZZZZZ. Perhaps this is different from the crap that they've been spewing for the last year, but if so, the changes are marginal. Uncoincidentally, APEC finance ministers had a go overnight, and the Chinese are also confronted with the prospect of finger-wagging Americans and Europeans washing up in Beijing over the next few weeks. The PBOC comments look like a bit of pre-emptive ass-covering, nothing more.

While one year CNY expectations are well off their pre-crisis lows, they are nevertheless within a hair's breadth of the their post-crisis lows. Macro Man struggles to see the fascination with playing this. With China, the best course of action is to "watch what I do, not what I say." And right now, they're doing nothin'.

Another blast from the past that has recently caught Macro Man's eye is the underperformance of small cap US equities. Last summer, Macro Man put on a large/cap small cap spread, which squeeeeeeeeeeezed painfully 'til he couldn't take it anymore, then promptly exploded higher after Lehman. Typical!

Anyhow, he's observed that the Russell 2000 has been a notable underperformer recently; in contrast to the SPX, for example, it is some 5% off its recent highs. Perhaps it is simply case of not being "too big to fail", or perhaps there's a more sinister aspect to the underperformance- e.g., strains from lack of access to credit. Regardless, while Macro Man's large cap/small cap proxy indicator (OEX/R2K) has popped recently, it's well off the highs of last year, let alone those from earlier in the decade. Perhaps readers who have focused on this more acutely could share thoughts on positioning in the large cap/small cap spread?

Elsewhere, there was a rather interesting and, frankly, puzzling development in the UK on Wednesday. In a marked change to the last year, the Bank forecast CPI inflation to be above target in 2 years with unchanged interest rates, and to be above target in three years with current QE and market interest rates. That's quite a change from prior reports, where the Bank had forecast an inflation undershoot over the relevant two year horizon.

From Macro Man's perch, that looked like a relatively hawkish change, on the margin. So naturally, the short sterling strip ripped higher; Dec 2011, for example, is up 20 bps since just before the release. Is Macro Man missing something here, or is the market smoking crack?

In any event, it's worth keeping an eye on the labour market. Macro Man's one-factor BOE model, based on data from the first nine years or so of the MPC's existence, continues to support the case for QE by prescribing sub-zero interest rates. Note, however, that it is turned up slightly....a development that Macro Man plans to watch with interest.

Who knows, maybe in a year or two Macro Man can revisit the relationship in another "blast from the past" moment....

Comments

[Alex Trias:]

Not sure if I already commented on the underperformance of US small caps or not. Then again, I can barely remember my own birthday. So, at the risk of repetition, I'm going with a theory that the Russell 2000 is underperforming the Dow Jones Industrial Average for at least one of two reasons. First, theory: we're approaching the end of the bull market, where risky assets typically tend to underperform relatively less risky assets. Second theory: as an equities fund manager, I'm paid to beat a benchmark, and 9 out of 10 times, that's the S&P 500. If I've been sitting in high beta stuff since March, my carried interest is looking pretty fat, and this would be a tempting moment to lock in. So, I dump my small caps, plow the capital into an S&P 500 index, and now I've locked in my performance. I think we're seeing a bunch of that. Part B of second theory: traders who enjoy life in the market-neutral zone recognize this temptation fund managers face to dump small caps and roll into large caps. So, said traders short Russell 2000 and go long the S&P 500. I'm pretty confident we're seeing some of that because that's a trade that I put on some weeks ago. I doubt I was alone.

Nov 17 01:34 PM