Market Capitalization: Large / Small

Highlights Policymakers vs. the virus remains the story at the macro level: Fiscal support is the wild card, but we expect Senate hawks, caught between the House and the White House, will roll over in the end. The economy is perking up, but it is still too vulnerable to stand on its own: The direction is improving as the economy reopens, but the level still stinks and COVID-19 has not gone away. We’ve reached an accommodation with rich index valuations, … : The alternatives are dismal, the preponderance of professional investors have to participate and the possibility of positive virus surprises cannot be dismissed. … but there’s plenty of silliness at the individual stock level: Retail investors, running amok like Donald Duck’s nephews, appear to have triggered some remarkable moves, especially in small stocks. Feature The big picture remains unchanged, but the view from ground level is becoming increasingly disorienting. The dizzying activity in vulnerable industries and select micro-caps resembles nothing so much as a beach bar after final exams. Sun, noise, adrenaline and a sense of overdue release have come together to wash away any and all inhibitions or standard rules. The pull has been especially strong for newcomers to the scene. We suspect that some of the unusual action in individual equities over the last several weeks may have its origins in an upsurge of active retail participation. Waves of retail interest come and go like the tides, albeit irregularly, and the only thing new about the current iteration, with its smart phone apps and zero commissions, is that it is nearly frictionless. We have nothing against retail investors – we’ve been one since directing our paper route earnings to the purchase of odd lots in Ronald Reagan’s first term – and don’t see them as a portent of doom. Their moves are drawing attention, though, so we review freely available daily data to try to gain some insight into their recent activity and ongoing interest. Novices Versus Experts Chart 1Baseline Change In Robinhood Equity Ownership Robinhood is a deep-pocketed retail brokerage oriented toward novice investors. Although its customers’ balances are almost certainly small, it has over 10 million of them, and it has made a profound impact on the industry by pioneering commission-free trading. Data on its customers’ holdings are aggregated and uploaded several times throughout the day to the dedicated website robintrack.net. They are cumbersome – the full database contains over 8,000 spreadsheets – so we focused our analysis on Robinhood customers’ holdings in airlines, cruise ships and selected mortgage REITs. We found that the number of Robinhood accounts owning these stocks exploded since late March, but that datapoint cannot be considered in isolation because the number of accounts has been rising. Robinhood added over 3 million new accounts in the first four months of the year, an increase of as much as 30% from its year-end customer base.1 A blizzard of anecdotal reports characterizing day trading as a substitute for following professional sports reinforce the notion that ownership of all stocks has risen. To get a sense of how baseline equity holdings have changed since the S&P 500 peak on February 19th, we looked at the number of Robinhood accounts holding Apple (AAPL) and the iShares (SPY) and Vanguard (VOO) S&P 500 Index ETFs, and found they have all roughly doubled (Chart 1). Making equity investing more democratic may be a noble aim, but democracy can be messy. By contrast, the number of Robinhood accounts holding six large- and mid-cap airlines has risen 48 times, with component holdings of United (UAL) and Spirit (SAVE) leading the way at 87 and 81 times, respectively (Chart 2, top two panels), and Southwest (LUV) and Jet Blue (JBLU) bringing up the rear at 12 and 21 times, respectively (Chart 2, bottom two panels). The number of accounts owning cruise lines is up 177 times, on average, powered by Norwegian (NCLH), which has increased a remarkable 365 times (Chart 3, top panel). If Robinhood’s customers are representative of the retail investor population, betting that the pandemic will not be fatal for passenger airlines and cruise lines has become an extremely popular pursuit. Chart 2Buying The Dip In The Airlines Chart 3Stampeding Into The Cruise Lines Chart 4Unafraid Of Falling Knives Robinhood customers have also eagerly attempted to rescue ailing mortgage REITs. Mortgage REITs apply several turns of short-term leverage to their mortgage portfolios to fund generous dividend yields that typically range between the high single and low double digits. Mortgage REITs that invest solely in agency mortgage-backed securities (MBS) were stressed when credit spreads blew out in March, but hybrid REITs with sizable concentrations of illiquid non-agency MBS and whole loans faced an existential crisis. Three hybrids – Invesco Mortgage Capital (IVR), MFA Financial (MFA) and AG Mortgage Investment Trust (MITT) – failed to meet margin calls from their repo lenders. MFA and MITT have indefinitely suspended their dividends, while IVR cut its dividend by 96% last week. The companies’ futures were in doubt in late March and early April, but Robinhood customers have poured into the breach. The number of accounts holding the stocks has risen 93-fold, on average, since the S&P 500 peaked in February, with IVR leading the way at 149 times (Chart 4, top panel). Robinhood customer interest began to surge when the three stocks bottomed but increasing numbers of accounts have added them to their portfolios all throughout a turbulent May and June. The stocks are not yet out of the woods and sell-side analysts have panned their recent surges, as it is unclear who else will want to own them when they don’t pay dividends. Stocks from the groups we highlighted all face daunting current predicaments. They might deliver sizable returns if they can emerge mostly unscathed but that is a big if. They have come to account for an outsized share of Robinhood customers’ holdings (Table 1), especially relative to their market capitalizations. Retail treasure hunting may account for some of the recent surges that seemed to spite fundamentals, but we doubt that a community of first-time investors has the heft to move any but the smallest stocks. We suspect that algorithms, hedge-funds and other fast-money pools of capital may be amplifying the momentum that retail activity has set in motion. Retail investors have provided institutions with an opportunity to exit stocks in the three stressed groups. Per weekly data on the level of institutional holdings from Bloomberg, the composition of ownership of all twelve stocks we examined has shifted materially from institutions to individuals (Table 2). In the case of these stocks, retail investors have served as liquidity providers to institutional sellers seeking to exit their holdings. Instead of amplifying volatility, they may have tamped it down, while helping to speed the redeployment of institutional capital. Table 1Searching The Bargain Bin Table 2Individuals Have Replaced Institutions   Direction Versus Level Many investors lament that the equity rally has occurred without regard for fundamental conditions or in seeming defiance of them. The imposition of rigorous social distancing measures to slow the spread of COVID-19 immediately induced a sharp recession, but the economy has begun to bounce back, and a further rollback of virus containment measures will help it build forward momentum. The latest NAHB survey demonstrated that housing is making rapid strides, with buyer traffic smartly reviving (Chart 5, third panel) and builders’ sales expectations snapping back (Chart 5, bottom panel). May housing starts came in well short of the consensus expectation, but leading building permits indicate that a pickup is just around the corner, and the purchase mortgage applications index hit its highest level in eleven years last week (Chart 6). Chart 5Housing Is Coming Back Fast Chart 6Low Rates Help The Real Economy, Too The various regional Fed manufacturing surveys all bounced in May, and the June Philly Fed (Chart 7, top panel) and Empire State (Chart 7, second panel) readings extended the trend, zooming far past expectations. Their moves bode well for the Richmond, Kansas City and Dallas Fed readings due out this week and next. They are not all the way back to their pre-pandemic levels, but they’re moving in the right direction and point to a continued pickup in manufacturing activity (Chart 8). Chart 7Gaining Traction The economic surprise index hit an all-time high last week (Chart 9), reinforcing the point that the improvement in the direction of economic activity is widespread. Activity has not returned to pre-pandemic levels, and it won’t for a while, but it is beginning to pick up or at least weaken at a slower rate. As states progress through their reopening phases, the direction will continue to improve and the level will get closer to its previous position. Chart 8Weak Level, Improving Direction Chart 9Uncoiling The Spring A resurgence in infection rates, or a second wave like the one that appears to be emerging in China, is a threat to ongoing economic improvement. Some states which have moved more rapidly to reopen are experiencing increasing infection rates, but they will only see reversals in economic activity if they revert to strict social distancing measures. It is becoming steadily apparent that most communities, here and abroad, no longer have the stomach for broad lockdowns. It seems that government officials are willing to trade a modest pickup in infections for a pickup in economic growth and individuals are willing to trade an increased risk of infection for a return to some sense of normal life. A severe re-emergence could change the calculus, but for now there is powerful momentum to advance along the path to restarting the economy. Policymakers Versus The Virus A record-high economic surprise index distills the improved direction across a broad sweep of indicators. Our view that Washington will extend fiscal lifelines to households, businesses and state and local governments is still intact. Negotiations over an infrastructure spending initiative are progressing, and we expect a successor to the CARES Act will follow before the end of July. As we’ve discussed before, it is simply too risky politically for Senate Republicans to obstruct aid efforts heading into the homestretch of the campaign. Robust fiscal support, combined with whatever-it-takes monetary support from the Fed, should be enough to see the economy across the pandemic abyss provided that testing bottlenecks are resolved and treatment protocols advance. Investment Implications Wagging a finger at retail investors is not our style. Increased retail participation has probably catalyzed some unexpected equity outcomes but the only outright distortions we’ve seen have occurred in micro-cap stocks and do not have a larger macro resonance. Retail participation in the stock market has always waxed and waned, but major market and economic impacts like the dot-com bubble are rare. We therefore do not believe that equities have become unmoored from reality and that a threatening bubble has formed. The fundamental backdrop has improved. The economy is nowhere near recovering its pre-pandemic levels, but the stock market is a forward-discounting mechanism and direction regularly trumps level. There is surely some froth in the market, and 24 times forward four-quarter earnings is a pricey multiple for the S&P 500, especially when it seems that earnings expectations beyond 2020 are overly optimistic. Retail participation in equities comes and goes, and it rarely proves disruptive at the overall index level. There are also plenty of ways that the virus could spring a nasty surprise, and financial markets seem to be ignoring them. Our geopolitical strategists see scope for turbulence at home, as the administration tries to improve its re-election prospects, and abroad, as any of several hot spots from Iran to North Korea to the South China Sea could flare up. The potential for negative surprises, as well as the furious equity rally, keeps us equal weight equities and overweight cash over the tactical timeframe. We remain constructive on equities over a 12-month horizon, however, as things are moving in the right direction and the alternatives – cash with zero yields and Treasuries with microscopic yields – are so unappealing.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Robinhood announced that it had surpassed the 10-million-customer mark in December.

Despite the strong rally in stocks since mid-March and a looming second wave of the pandemic, we continue to recommend that investors overweight equities on a 12-month horizon. Needless to say, this view has raised some eyebrows. With that in mind, this week we present a Q&A from the perspective of a skeptical reader who does not fully share our enthusiasm. Q: You said last week that a second wave of the pandemic is now your base case, yet you’re still sticking with your positive 12-month equity view. Why? A: A second wave of the pandemic, along with uncertainty about how the coming fiscal cliff in the US will be resolved, could unnerve investors temporarily. Nevertheless, we expect global equities to rise by about 10% from current levels over the next 12 months, handily outperforming bonds. While low interest rates and copious amounts of cash on the sidelines will provide a supportive backdrop for stocks, the main impetus for higher equity prices will be a recovery in economic activity and corporate profits. Q: It is hard to see the economy recovering very much if there is a second wave. A: It is important to get the arrow of causation right. Part of the reason we expect a second wave is because we think policymakers will continue to relax lockdown measures even if, as has already occurred in a number of US states, the infection rate rises. Granted, a second wave will moderate the pace at which containment measures can be dismantled. It will also prompt people to engage in more social distancing. Thus, a second wave would make the economic recovery slower than it otherwise would have been. However, it is doubtful that growth will grind to a halt. The appetite for continued lockdowns has clearly waned. For better or for worse, most western nations will follow the “Swedish model” of trying to limit the spread of the virus without imposing draconian restrictions on society. Chart 1CBO Projects The Unemployment Rate Will Fall Very Slowly Q: Even if the Swedish model works, and I doubt it will, we are still in a very deep economic hole. The unemployment rate in many countries is the highest since the Great Depression. The Congressional Budget Office does not foresee the US unemployment rate falling below 5% until 2028. A return to positive growth seems like a very low bar for success. We may need many years of above-trend growth just to get back to the pre-pandemic level of GDP! A: The Congressional Budget Office is too pessimistic in assuming that the recovery will be as sluggish as the one following the Great Recession (Chart 1). That recovery was weighed down by the need to repair household balance sheets after the bursting of a debt-fueled housing bubble. The current downturn was caused by external forces – an exogenous shock in econospeak. Historically, recoveries following exogenous shocks have tended to be more rapid than recoveries following recessions that were instigated by endogenous problems. Q: That may be so, but Wall Street is already penciling in a very rapid recovery. Last I checked, analysts expect S&P 500 earnings next year to be close to where they were last year. A: One has to be careful when comparing earnings estimates with economic growth projections. Chart 2 shows a breakdown of S&P 500 EPS estimates by sector. Appendix A also shows the evolution of these estimates over time. While analysts expect overall earnings per share (EPS) to return to last year’s levels in 2021, this is mainly because of the resilient profit outlook in the technology and health care sectors (the two biggest sectors in the S&P 500 by market cap). Outside those two sectors, EPS in 2021 is expected to be down 8.6% from 2019 levels, or 11.2% in real terms. Chart 2Breakdown Of S&P 500 EPS Estimates By Sector If one looks at the cyclically-sensitive industrials sector, earnings are projected to fall by 16% between 2019 and 2021. Energy sector earnings are projected to decline by 65%. Earnings in the consumer discretionary sector are expected to decline by 8%, despite the fact that Amazon accounts for nearly half of the sector by market cap.1 This suggests that analysts are expecting more of a U-shaped economic recovery than a V-shaped one. Chart 3The Present Value Of Earnings: A Scenario Analysis Q: Fair enough, but I am ultimately more interested in what the market is pricing in than what analysts are expecting. It seems to me that stock prices have rebounded much more rapidly than one would have anticipated based on the evolution in earnings estimates. A: That is true, but it is important to keep in mind that the fair value of the stock market does not solely depend on the expected path of earnings. It also depends on the discount rate we use to deflate those earnings. For the sake of argument, let us suppose that S&P 500 earnings only manage to reach $144 per share next year (10% below current consensus) and take five years to return to their pre-pandemic trend. All things equal, such a decline in earnings would reduce the present value of stocks by 4.2% relative to what it was at the start of the year (Chart 3). However, all things are not equal. The US 30-year Treasury yield, adjusted for inflation, has declined by 59 basis points this year. If we use this real yield as a proxy for the discount rate, the fair value of the S&P has actually increased by 8.7% since January 1st, despite the decline in earnings. Q: I think you’re doing a bit of a bait and switch here. You’re assuming that earnings estimates return to trend by the middle of the decade, but that long-term bond yields remain broadly unchanged over this period. If the economy and corporate earnings recover, won’t bond yields just go back to where they were last year, if not higher? A: Not necessarily. Conceptually, there is not a one-to-one mapping between interest rates and the full-employment level of aggregate demand.2 For example, consider a case where an adverse economic shock hits the economy, making households and businesses more reluctant to spend. If that were all there was to the story, the stock market would go down. But there is more to the story than that. Suppose the central bank cuts interest rates in response to this shock, which boosts demand by enough to return the economy to full employment. Now we have a new equilibrium where the level of demand – and by extension, the level of corporate profits – is the same as before but interest rates are lower. The fair value of the stock market has gone up! Q: Hold on. Central banks came into this recession with little fire power left. I agree that their actions have helped the stock market, but they have not been enough to rehabilitate the economy. A: Good point. That is where the role of fiscal policy comes in. One of the unsung benefits of lower interest rates is that they have incentivised governments to borrow more at a time when the economy needs all the fiscal support it can get. As Chart 4 shows, the fiscal response during this year’s downturn has been significantly larger than during the Great Recession. Thus, it is more correct to say that the combination of lower interest rates and fiscal easing have conceivably increased the fair value of the stock market. Chart 4Fiscal Stimulus Is Greater Today Than It Was During The Great Recession Q:  And yet despite all this fiscal and monetary support, GDP remains depressed. A: The point of the stimulus was not to raise output or employment. It was to keep households and businesses solvent during a time when their regular flow of income had dried up. Q: If households and businesses did not spend much of that money, where did it go? A: Much of it remains in the banking system. The US savings rate shot up to 33% in April. As Chart 5 illustrates, this was almost perfectly mirrored by the increase in bank deposits. Anyone who claims that savings have nothing to do with deposits should study this chart. Chart 5Lots Of Savings Slushing Around   Chart 6Stocks That Are Popular With Retail Investors Are Outperforming Q: And now, I suppose, these deposits are flowing into the stock market? A: Correct. That is one reason why stocks popular with retail investors have outperformed the S&P 500 by 30% since mid-March (Chart 6). Q: Have these retail flows really been important enough to matter? A: They have probably been more important than widely portrayed. Many of the online brokerages touting zero-commission trades make their money by selling order flow to hedge funds. Thus, the trading of individuals is magnified by the trading of institutional investors. More liquid markets tend to generate higher prices. There is also another subtle multiplier effect worth considering. You mentioned that money was “flowing into the stock market.” Technically speaking, “flow” is not the best word to use. For the most part, if I decide to buy some shares, someone else has to sell me their shares. On a net basis, there is no inflow of cash into the stock market. Rather, what happens is that my buy order lifts the price of the shares by enough to entice someone to sell their shares. Thus, if retail investors bid up the price of stocks to the point that institutions are forced to sell, those institutions are now left with excess cash that they have to deploy elsewhere in the stock market. As the value of investors’ stock portfolios rises, the percentage of their net worth held in cash falls. This game of hot potato only ends when the percentage of cash held by investors shrinks to a level that is consistent with their preferences. Importantly, this means that changes in the amount of cash on the sidelines can have a “multiplier” effect on stock prices. For example, if cash holdings go up by a dollar, and people want to hold ten times as much stock as cash, then stock market capitalization has to go up by ten dollars. Q: How far along are we in this game of hot potato? A: Despite the rally in stocks since mid-March, cash held in money market funds and savings deposits is still 10% higher as a share of market capitalization than at the start of the year. This suggests that the firepower to fuel further increases in the stock market has not been fully spent. Chart 7Equity Risk Premium Is Still Quite High Q: Wouldn’t you think that after a pandemic people would be more risk-averse and hence inclined to hold more cash? A: That would be a logical assumption, but it is not clear whether it is empirically true. There is some evidence from the psychological literature that people who survive life-threatening events tend to become less risk averse rather than more risk averse after the event has passed.3 A pandemic seems to qualify as a life-threatening event. In any case, when considering the equity risk premium, we should not only think about the riskiness of stocks; we should also think about the riskiness of bonds. Bond yields are near record lows. To the extent that yields cannot fall much from current levels, this makes bonds a less attractive hedge against downside economic news than they once were. So perhaps the equity risk premium, which is still quite high, should actually be lower than it currently is (Chart 7). Q: It seems that much of your optimism is based on the assumption that policy will stay stimulative. On the monetary side, that seems like a safe assumption. However, as you yourself mentioned at the outset, there is a risk that stocks will be upended by a premature tightening in fiscal policy. A: This is indeed a risk. In the US, the Paycheck Protection Program (PPP) will run out of funds over the coming month. The additional $600 per week in benefits that jobless workers are receiving will expire on July 31st, causing average unemployment payments to fall by about 60%. Direct payments to households have also ceased. Together, these three fiscal measures amount to about 5.5% of GDP. Furthermore, most states begin their fiscal year on July 1st. Despite receiving $275 billion in federal aid, they are still facing a roughly $250 billion (1.2% of GDP) financing shortfall in the coming fiscal year, which could force widespread layoffs. The good news is that both Republicans and Democrats want to avert this fiscal cliff. While negotiations over the next stimulus package could unnerve investors for a while, they will ultimately culminate in a deal. The Democrats want more spending, as does the White House. And if public opinion polls are to be believed, congressional Republicans will also cave in to voter demands for continued fiscal largess (Table 1). Table 1There Is Much Public Support For Fiscal Stimulus Q: It seems to me that the fiscal cliff is not the only political risk to worry about. Tensions with China are running high and there is domestic unrest in many cities around the world. Even if fiscal policy remains accommodative, President Trump will probably lose in November. This makes a repeal of his tax cuts more likely than not. A: It is true that betting markets now expect Joe Biden to become president (Chart 8). They also expect Democrats to regain control of the Senate. My personal view is that Trump has a better chance of being reelected than implied by betting markets. While the protests have hurt Trump’s favorability ratings in recent weeks, ongoing unrest could help him, given his claim of being the “law and order” president. It is worth recalling that after falling for more than 20 years, the nationwide homicide rate spiked by 23% between 2014 and 2016 following protests in cities such as St. Louis and Baltimore (Chart 9). This arguably helped Trump get elected, just like the Watts Riot in Los Angeles helped Ronald Reagan get elected as Governor of California in 1966. Chart 8Betting Markets Now Expect Joe Biden To Become President If Senator Biden were to prevail, then yes, Trump’s corporate tax cuts would be in jeopardy. A full repeal of the Trump tax cuts would reduce EPS of S&P 500 companies by about 12%. Chart 9Continued Unrest May Help Trump, As It Has In The Past However, it is possible that Democrats would choose to only partially reverse the corporate tax cuts, while also lifting taxes on higher-income households. One should also note that trade tensions with China would probably diminish under a Biden presidency, which would be a mitigating factor for equity investors. Chart 10Cyclical Sectors Should Outperform Defensives As Global Growth Recovers... And A Weaker Dollar Should Also Help Non-US Stocks Q: So to sum up, you are still bullish on stocks over a 12-month horizon, although you see some near-term risks stemming from the likelihood of a second wave of the pandemic and uncertainty about how and when the fiscal cliff problem in the US will be resolved. What are your favorite sectors, regions, and styles? A: Cyclical sectors should outperform defensives over the next 12 months as global growth recovers. Cyclicals are overrepresented outside the US, which should favor overseas markets. A weaker dollar should also help non-US stocks (Chart 10). The dollar generally trades as a countercyclical currency, implying that it will sell off as global growth recovers. Moreover, unlike last year, the greenback no longer enjoys the benefit of higher interest rates than those abroad. In terms of style, value should outperform growth. Growth stocks have done very well in a falling interest rate environment (Chart 11). However, interest rates cannot fall much further from current levels. Small caps should outperform large caps, both because small caps are more growth-sensitive and because they tend to be more popular among day traders. Google searches for “day trading” have spiked in the past few months (Chart 12). Chart 11Interest Rates Cannot Fall Much Lower From Current Levels, Which Will Allow Value To Outperform Growth Chart 12Day Trading Is Back In Vogue These Days Beyond the pure macro plays, the pandemic could lead to a number of unexpected changes that have yet to be fully discounted by markets. For example, we will likely see a surge in the demand for automobiles as people shun public transit. The pandemic could also accelerate the reshoring of manufacturing activity, particularly in the health care sector. Contract manufacturing companies with significant domestic operations will benefit. Additionally, more people will move to the suburbs to work from home and escape the virus and rising crime. This could boost the demand for new houses and lift suburban real estate prices. Since most suburbs are built on top of land previously zoned for agriculture, farmland prices could also rise. Appendix A Evolution Of S&P 500 EPS Estimates By Sector Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  Amazon EPS is projected to rise by 54% between 2019 and 2021, from 11% of overall consumer discretionary earnings to 19%. 2 One can see this within the context of the IS-LM model that is taught to economics undergraduates. If the LM curve shifts outward while the IS curve shifts inward, one could end up with the situation where aggregate demand is the same as before, but the equilibrium interest rate is lower. 3  For example, Gennaro Bernile, Vineet Bhagwat, and P. Raghavendra Rau investigated the link between the intensity of early-life experiences on CEO’s attitudes towards risk. Their results suggest that CEOs who witnessed extreme levels of fatal natural disasters appear more cautious in approaching risk. In contrast, those that experience disasters without very negative consequences become desensitized to risk. For details, please see Gennaro Bernile, Vineet Bhagwat, and P. Raghavendra Rau, “What Doesn't Kill You Will Only Make You More Risk-Loving: Early-Life Disasters and CEO Behavior,“ The Journal of Finance, (72:1) February 2017.   Global Investment Strategy View Matrix Current MacroQuant Model Scores

Neutral We recently capitalized gains of 37% in our size bias and moved to neutral in the S&P 500 / S&P 600 share price ratio as our 10% rolling stop was hit. In addition, in the most recent Weekly Report we highlighted a number of improvements for US small caps: peaking relative job proxy, bottomed profit margins, and crested indebtedness. Today, we also add a historical angle to the picture. The chart highlights US large and small caps average performance during the top 10 steepest monthly falls since 1978, as well as the subsequent 1-year average return. Small caps generally underperform their large caps pears by 5% entering a crisis, but outshine large caps by 9% on average in the following 12 months. Bottom Line: Stay neutral the size bias, but stay tuned.  

Highlights Portfolio Strategy An easy Fed as far as the eye can see and World War-like fiscal easing packages as the Trump administration prepares to slowly reopen the economy, signal that the path of least resistance remains higher for the S&P 500 in the coming 9-12 months. Relative indebtedness and profit margin improvements, extremely oversold technicals and significant relative undervaluation along with an encouraging message from financial market indicators, all suggest that it no longer pays to have a large cap bias. Book gains and step aside. Recent Changes Our long S&P 500/short S&P 600 position was stopped out last Tuesday for a 37% gain since inception.1 Last Wednesday our rolling stop was also triggered on the overweight in the S&P managed health care index – it is now neutral – for a gain of 26% since inception.2 Table 1 Feature The SPX made a run for the technically important 200-day moving average last week, and managed to climb to fresh recovery highs before giving back those gains as profit taking intensified late in the week. Three key drivers underpinned stocks and dominated the newsflow: First, resurfacing of positive news on remdesivir, a GILD drug, in treating the novel coronavirus. Second, the Fed reiterating its commitment to ZIRP and QE5 (Chart 1). And third, the quintuplet tech titans (MSFT, AAPL, GOOGL, AMZN & FB) reporting solid profits and April guidance, thus alleviating investors’ fears of a complete breakdown in tech revenues and EPS. Chart 1Easy Central Bank Monetary Policy Stance… Tack on the World War-like fiscal easing packages (Chart 2) and the path of least resistance remains higher for the S&P 500 in the coming 9-12 months. Chart 2…And An Easier Fiscal Policy Setting Are A Boon For Stocks Granted all of these monies are finding their way into the markets not only via higher asset prices, but also – and most crucially – the Fed’s massive liquidity injection is suppressing volatility. First, Fed actions have crushed the bond market’s vol, as depicted by Bank Of America’s MOVE index, that has now crumbled to a level last seen prior to the equity market drubbing. Similarly, the Fed has also quashed the VIX index which is now hovering near 35, down from a peak of 85 last month. Importantly, volatility petered out prior to the equity market’s trough, and so did different volatility curves (volatilities and volatility curve shown inverted, Chart 3). Turning over to S&P 500 net earnings revisions (NER), this mean reverting series was first tracked by I/B/E/S in 1985, and two weeks ago collapsed to the nadir of the GFC (Chart 4). Every time the NER ratio has hit such depressed levels, stocks have subsequently staged a powerful comeback. This has occurred five distinct times in the past 35 years and the SPX was 15% higher on average in the following twelve months (Chart 4). Chart 3Vols Lead On The Way Up And Down   Chart 4Extremely Depressed Net Earnings Revisions Have Troughed Drilling deeper beneath the surface is revealing. Analysts have been indiscriminately downgrading profits across all sectors. True, last week’s update revealed a tick up, which is an encouraging sign that the avalanche of downgrades may have already hit a climax (Charts 5 &  6). Chart 5Too Much Pessimism… Chart 6…Across The Board Importantly, our in-house calculated SPX sector EPS breadth is probing all-time lows. But, if the Fed manages to devalue the US dollar then a sharp reversal will ensue. Keep in mind, that the greenback and our EPS breadth indicator are inversely correlated as 40% of SPX sales are sourced internationally (Chart 7). Chart 7As Bad As It Gets Finally, a few words on the character of the equity market’s advance since the March 23 lows are in order. Contrary to popular belief, this has been an extremely broad based rally and the stocks that have done the best are not the large/mega caps. Instead the median stock has far outpaced the top market cap ranked constituents. In other words, the stocks that have rebounded the most are the ones that had fallen the most. Using Bloomberg data on SPX constituents from the March 23 lows until April 28, the first mega cap company that makes it to the top return ranks is CVX at the 22nd spot. UNH is 85th, ABT 90th and XOM 132nd. The tech titans start appearing below the 350th mark with MSFT 353rd, AAPL 362nd, FB 370th, AMZN 394th and GOOGL 439th. In other words, both the Value Line Arithmetic and Geometric indexes have been outperforming the SPX since the March 23 lows (top & middle panels, Chart 8). Similarly, small caps have also been besting the SPX (bottom panel, Chart 8). Notably, all three of these hypersensitive indexes have also led the SPX bottom. This week, we update our size view that was stopped out last Tuesday as the rolling stop was triggered for a gain of 37% since inception, and do some housekeeping. Chart 8Broad Based Rally Lock In Profits In the Size Bias And Move To The Sidelines In the spring of 2018 we initiated a size preference of large caps at the expense of small caps. At the time, we went against the grain as the investment community was arguing that small caps would offer the best protection from President’s Trump trade hawkishness. Their reasoning was that small caps are domestically oriented and would benefit from a rising dollar given low export exposure. While we were slightly offside for a quarter, this size preference recouped all the losses by October 2018, and never looked back since then. Our thesis was predicated upon relative indebtedness, relative profitability and relative profit margin outlook, all of which were in favor of large caps. Earlier this year when markets were convulsing we instituted a risk management metric with a rolling 10% stop on this size preference in order to protect profits for our portfolio.3 This past Tuesday our 10% rolling stop was triggered and we are obeying this stop, monetizing 37% gains since inception and we are moving to the sidelines on the size bias (Chart 9). Chart 9Take Profits And Move To The Sidelines Following a near collapse to two standard deviations below the six year mean, small cap performance has returned to the mean and is primed to sustain this reflex rebound. In marked contrast, large caps only corrected to their six year average and are now trading at over one standard deviation above that mean (Chart 10). When the economy was shut down small and medium businesses were clearly the outfits that would hurt the most. Their only rescue came belated in the form of the fiscal package. Thus, investors started pricing in a steep default cycle with SMEs at the forefront of the bankruptcy curve (top panel, Chart 10). In contrast, large caps with access to untapped credit lines, the bond and equity markets as well as their own cash coffers would not suffer as severely (second panel, Chart 10). Chart 10Large Cap Outperformance Reached An Extreme Now that the economy is on the verge of slowly reopening, we do not want to overstay our welcome and refrain from betting on a further jump in the large/small ratio; instead we opt to book profits and move to the sidelines. With regard to profit fundamentals, our relative jobs proxy has peaked and is no longer favoring large caps (second panel, Chart 11). Similarly, profit margins have likely bottomed for small caps while they have maxed out for large caps (third panel, Chart 11). On the relative indebtedness front, small cap net debt-to-EBITDA remains sky high but it has crested which is at the margin positive (bottom panel, Chart 11). Meanwhile, as the Fed has opened up the liquidity spigots, the government is as spendthrift as it can be and committed to slowly reopen the economy, then at some point in the summer the pendulum will swing the opposite way and some semblance of normality will return to the US economy. Therefore, this inflection point will end the threat of deflation and likely serve as a catalyst for a small/large multiple expansion phase (Chart 12). Chart 11Marginal Small Cap Improvements Chart 12When The Economy Turns, So Will Small Caps With regard to the message that financial market variables are sending for the small/large ratio, the collapse of the VIX is a welcome development (VIX shown inverted, Chart 13). Similarly, the yield curve has been in steepening mode again emitting a positive “risk on” signal. Under such a backdrop and given depressed technicals and bombed out valuations it is prudent not to wager against small caps at this juncture (Chart 14). Chart 13Leading Financial Market Indicators Say Do Not Overstay Your Welcome Chart 14Unloved And Undervalued Netting it all out, relative indebtedness and profit margin improvements, the slow reopening of the economy in the coming months, extremely oversold technicals and significant relative undervaluation along with an encouraging message from financial market indicators, all signal that it no longer pays to have a large cap bias. Bottom Line: Move to the sidelines on the size bias and crystalize profits of 37% since inception. Housekeeping Last Wednesday our rolling stop was also triggered on the overweight in the S&P managed health care index – it is now neutral – for a gain of 26% since inception (top panel, Chart 15).4 In addition, we are stepping aside from the COVID-proof basket of stocks we recommended six weeks ago.5 The coronavirus unintended consequences will alter government, business and consumer behaviors and it will most definitely affect consumer tastes, underscoring that the companies that comprise our COVID profit basket will likely be long-term winners. However, this basket has served its purpose and given that the global economy is on the verge of reopening it will be increasingly difficult to outperform the broad market. Thus, we are moving to the sidelines for a modest relative gain of 0.8% (second & third panels, Chart 15). Finally, our freshly minted market-neutral and intra-commodity long S&P oil & gas exploration & production/short global gold miners pair trade has gone parabolic right out of the gate soaring to 20% in a mere week. As a result of this explosive up-move, we are instituting a 10% rolling stop in this pair trade in order to protect profits for our portfolio (bottom panel, Chart 15). Chart 15Housekeeping     Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     Footnotes 1    Please see BCA US Equity Strategy Daily Report, “Book Gains In Preferring Large Caps To Small Caps” dated April 30, 2020, available at uses.bcaresearch.com. 2    Please see BCA US Equity Strategy Daily Report, “Take Profits In HMOs And Move To The Sidelines” dated May 1, 2020, available at uses.bcaresearch.com. 3    Please see BCA US Equity Strategy Daily Report, “Closing Out All High-Conviction Calls” dated March 20, 2020, available at uses.bcaresearch.com. 4    Please see BCA US Equity Strategy Daily Report, “Take Profits In HMOs And Move To The Sidelines” dated May 1, 2020, available at uses.bcaresearch.com. 5    Please see BCA US Equity Strategy Daily Report, “Corona Virus Proof Portfolio” dated March 18, 2020, available at uses.bcaresearch.com. Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert)  January 22, 2018 Favor value over growth April 28, 2020  Stay neutral large over small caps  June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).

In the spring of 2018 we initiated a size preference of large caps at the expense of small caps. At the time, we went against the grain as the investment community was arguing that small caps would offer the best protection from President’s Trump trade hawkishness. The reasoning was that small caps are domestically oriented and would benefit from a rising dollar given low export exposure. While we were slightly offside for a quarter, this size preference recouped all the losses by October 2018 and never looked back since then. Our thesis was predicated upon relative indebtedness, relative profitability and relative profit margin outlook, all of which were in favor of large caps. Earlier this year when markets were convulsing we instituted a risk management metric with a rolling 10% stop on this size preference in order to protect profits for our portfolio.1 Bottom Line: This past Tuesday our 10% rolling stop was triggered and we are obeying this stop, monetizing 37% gains since inception and we are moving to the sidelines on the size bias. Please look forward to reading our upcoming Weekly Report for a more detailed discussion of why we are compelled to move to a neutral size bias. Footnotes 1    Please see BCA US Equity Strategy Daily Report, "Closing Out All High-Conviction Calls" dated March 20, 2020, available at uses.bcaresearch.com.

Equity market bloodletting likely reached a climax last Thursday as indiscriminate selling pushed correlations to the extremes of +/-1. Since then however, hypersensitive stocks have made an attempt for a comeback. These greenshoots are most visible in the highest beta areas of the market, namely chip stocks and small cap indexes. The chart shows that both the Philly SOX index and the Russell 2000 are ticking higher versus the NASDAQ 100 and S&P 500 indexes, respectively. While it is still too soon to call the ultimate trough in stocks and a retest will likely materialize, it is encouraging that investors are no longer pressing the panic sell button. Tack on the extreme short interest and lack of depth in ES futures and a significant short-covering reflex rally is likely to continue in the coming days.  Bottom Line: We recommend investors with higher risk tolerance and a 9-12 month cyclical time horizon to continue nibbling on the broad equity market.​​​​​​​

There is a lot of uncertainty that reverberates through the equity markets and the dust has yet to settle down from Monday’s big crack. Small caps (similar to weak balance sheet stocks, middle panel) have cratered for three reasons: First, they are massively indebted as the bottom panel of the chart shows not only in absolute terms, but also compared with their large cap brethren. Second, small caps have been mired in earnings deflation for a while and the looming recession now aggravates the fall in these high beta stocks. Finally, small caps have a large weighting in financials in general and small regional banks in particular. As such, the recent double whammy of the oil price collapse and bond yield plunge has wreaked havoc in small cap indexes. We have been cyclically avoiding small caps and instead preferring large caps since mid-2018 and late-last year we also added this size preference to our high-conviction call list as a modest hedge to most other high-conviction calls that were levered to higher interest rates. Today, from a portfolio risk management perspective, we are instituting a trailing stop at the 10% return mark in order to protect gains. Bottom Line: Stick with the large cap bias for a while longer.