When Small Caps Get Hit, Ultrashort Russell Will Bounce

A theme I keep returning to is, in a slowing US economy the small caps will get hurt more than the large caps even though the large cap indexes are dominated by financials (20% of indexes in many cases).

Thursday is an example with the Russell 2000 (-2.8%) off by a factor of 2 versus the S&P 500 (-1.4%)

When the markets truly fall, they are somewhat indiscriminate but Thursday was not one of those days - for example the fertilizer stocks are holding up very well, as are a few other sectors. So on days when the market throws everything off, it really doesn't matter what you hold, or what you are short. But on days like Thursday, holding shorts that are more narrow such as the UltraShort Russell 2000 (TWM) +5.5% and UltraShort Financial (SKF) +6.5% are a boon.

I don't see these trends changing anytime soon. The US consumer is in trouble, and I don't think the Wall Street white shoes crowd gets it yet. Seventy percent live paycheck to paycheck. No matter what income level. This was sustainable in the past as spending was capitalized on the balance sheet by putting extra expenses into home equity appreciation (i.e. loans). That no longer works for those 70%.

And on top of that they have real inflation now attacking them. Health care has been eating them for years. Then energy. Next came food. Now comes consumables, as Procter & Gamble mentioned in its earnings call. Paycheck to paycheck lifestyle does not allow for 7-10% increases in these items each year. Not with incomes going up 3-4% (most of which is eaten by higher health care premiums each year). This is what the "consumer is fine" crowd does not get. Yet in the past when times like this hit, the consumer just ran to mortgage broker and extracted another $10-$20K out of house. That game is over (for now).

What saddens me is what got us in this mess, is just repeating. The Fed is going to push down rates, and play the same game that we did in 2002-2003 -I hope in due time housing rebounds so the overstretched consumer can eventually recapitalize their growing debt (which they are now pushing onto credit cards) back into their homes. Its like a drug addict, going back to the same well over and over to scratch that itch. However it will be less effective each time.

This "game" will rely on two things - home prices rebounding and suckers being born yet again in institutional investing who will buy securitized layers of junk. I just don't see that as a solution that is going to bail anyone out in the next 12-24 months. However, I am confident, just like we have forgotten in just half a decade about the off balance sheet accounting and lack of regulation of the Enron, Tyco, Worldcom, era (which amazingly has now been institutionalized in our major financial institutions with their SIVs) that a half decade from now we will be back to the same game - creating new exotic ways to push off debt for the consumer. And they will tell you it's different this time. And it will just be forestalling an inevitable truth - we live above our means, and will create new ways to do so; one way or the other. But that's the long run.
And eventually in this increasingly flat world, that game will be less and less effective on each iteration.

What is scary is the near term, the next couple of years. Since people do not have memories which are that short- I don't know where all this new debt is going to be created from. So instead the Fed has decided to throw massive amounts of liquidity into the system. Great for the upper 2% and corporations. I don't see how its going to help average Joe. Average Joe is facing factors he never felt before in the 'flat world'. Average Joe is getting displaced from the safe job he had for many years at relatively good wage, and instead is doing service job paying 10-20% less. Yet lives the same (or higher lifestyle).

These are very long term trends that are incrementally creeping onto the US, but happen so slowly people do not really realize it. Exporters (15% of economy since we've gutted our export industry) will be living the high life, (large) corporations flush with cash and passing along price increases will be living the high life (still), worldwide emerging middle class will be living the high life, but many here won't be.

This has been happening the past half decade but it was hidden behind the mirage of home price increases. Now we will see what the reality is when we don't have the home equity to stash our growing debt. And expect those trends to be hitting small(er) companies reliant on the US consumer.

This "housing is 5% of the economy" blabber is really the biggest misnomer. Ripple effects are many, and just beginning. And yes the markets can continue up in the face of all this, simply due to supply/demand dynamics - not enough supply of stock and a storm of liquidity being created by the Fed. Doesn't mean (to me) a sign that the economy will be great in six months... which is what the market used to signify. Now it just signifies ever more useless dollars hitting the world and propping up stocks.

Disclosure: Long UltraShort Russell2000, UltraShort Financial in fund and in personal account