Bring On The Risk?

Michael Gayed, CIO at Pension Partners, writes that the small-cap message is clear: Bring on the risk:

Earlier this month, I wrote an article arguing that "a strong bounce can soon occur as small-caps themselves begin to rally in August at a faster pace than the S&P 500.

Read "Small-caps reach pre-'melt-up' extreme."

Given that August is the strongest month of the year during an election year, historically, leadership here combined with a continuation in weakness in the bear trade and easing of dividendsanity, alongside rising inflation expectations, all equates to a potent environment for equities." I thought it might be appropriate to revisit the small-cap message in light of the more recent period of strength in high beta stocks.

First, let's review why watching the behavior of small-cap stocks can be telling. Characteristically, small-cap stocks (generally those with a market capitalization of under $2 billion) are 1) less liquid and have less dollar volume than large-caps, 2) are more sensitive to the domestic economy and the consumer than large-caps because of having less global reach, and 3) have higher price volatility.

Strong bull markets tend to be characterized by leadership and outperformance in small-cap stocks as money grows more confident about the future and positions for higher risk with higher return potential.

Bull markets do not have to be led by small-cap stocks as evidenced by several years in the 1990s, but powerful moves can result when they are. Clearly the S&P 500 SPX +0.51% has been the big winner thus far in 2012 as money favored liquidity when taking equity risk, but that appears to be changing. Take a look below at the price ratio of the Russell 2000 ETF IWM +0.41% relative to the S&P 500 IVV +0.57% . As a reminder, a rising price ratio means the numerator/IWM is outperforming (up more/down less) the denominator/IVV. See a larger version of the chart.

Note the similarity in the relative price performance of the small/large-cap ratio between now and the fall melt-up of 2011. The strength in small-caps appears to be quite early, and the trend up for now remains intact. It could very well be that as bets increase on further stimulus (QE4, NOT QE3 since that already happened through the negative narrative trade), money is positioning for a pickup in domestic strength driven by central bank action.

The message is simple and clear — strength in small-caps means risk sentiment is improving as money grows more confident in less liquid names. This, alongside other intermarket trends, continues to suggest that the trend higher in equities remains likely to continue and that risk taking is just getting started in the stock market.

Is Michael right? Is now the time to load up on small-caps? Not sure. Let me explain. It's true that strength in small-caps means risk sentiment is improving. This means that high beta stocks will outperform their low-beta counterparts going forward.

But following the crisis in 2008, pension funds, mutual funds and hedge funds are all managing their liquidity risk more carefully. This means that hedge funds, which traditionally were very active in the small-cap space, are less active than in the past.

Moreover, as more and more assets pile into fewer and fewer hedge funds, there is a large-cap bias built into how these funds invest their money. You can review top funds Q2 activity and see this bias in action.

Does this mean top hedge funds don't take risk? Absolutely not. They take risk in high beta, large cap tech stocks, energy and in financials, but are a lot more weary of taking risk in small-caps. This will change if a broad economic recovery takes hold, but the days of high-flying small-caps are not back, at least not yet.

Having said this, I agree with Michael that now is the time to be taking risk. On Friday, the Fed kept stimulus in play, lifting up Wall Street. Still think that the Fed will not engage in more quantitative easing, but risk assets, especially gold and silver took off on the news.

I was a little mad at myself for not playing Agnico-Eagle Mines (AEM), one of my favorite plays in the gold space (click on image to enlarge):

Others, like Paulson, are playing the SPDR Gold Share Index (GLD), and many others are piling into iShares Silver trust (SLV) erroneously believing this is the beginning of a major breakout, not bubble, in gold and silver.

I take a more tempered view, believing you can trade gold and silver but you'd better take your profits or else you'll get creamed. I agree with those who note gold miners (GDX) are now overbought and could face a sharp correction. Unlike many however, I just don't see a major breakout in gold. Good to trade but be careful.

What I do see is a continuation of the stealth melt-up, focusing primarily on US financials (love JPM, take some profits on big 5 Canadian banks), energy (think Encana is best option at moment), and technology stocks like Cisco (CSCO), Juniper (JNPR), Ciena (CIEN), NetApp (NTAP) and EMC Corporation (EMC). I also like US coal stocks which have been decimated and are finally drawing bullish option activity.

What about Apple Inc. (AAPL)? Isn't everyone in the world going to buy an iPod, iPad and iPhone? Will the stock smash through $1000? Maybe it will but I think people have had their fill of Apple hyping their products. I own an iPod and iPad (no need to upgrade), but will never give up my BlackBerry (RIMM) and think that many people, like my dad, couldn't care less of Apps and slick marketing. They'll stick with their good old Nokia (NOK) cellular phones.

What else are investors looking for? In tough times, more and more investors will demand good old dividends from Dow companies like AT&T (T) and Verizon (VZ). Overseas, they're playing France Telecom (FTE) and Vodaphone (VOD). There is a reason why investors are seeking out these high yielding stocks, demographics and low rates on government bonds.

Finally, Francois Trahan recently spoke with Consuelo Mack on WealthTrack and stated his belief that the equity market is mid-way through a melt up. He believes this could last through the end of the year and possibly into the first quarter of 2013.

Just a reminder, Francois is a top-ranked strategist at Wolfe Trahan & Co who recently opened up his hedge fund, Trahan Capital Management, right here in Montreal. Listen to the interview below done in mid July where he rightly notes buy & hold is dead and that in a low growth era, dividends will make a huge difference in your portfolio.