Despite the rough start to the year, Bank of America had maintained its tactically bullish stance on US small cap equities on the idea that small caps are the best-positioned to benefit from increasing optimism around stimulus and tax reform. And it has been right: as we showed earlier, Russell hit a fresh all time high…
… facilitated by the recent influx of bears who brought net specs positioning to the shortest on record, and have been once again squeezed.
Yet even BofA’s optimism ended overnight when the bank officially capitulated on its bullish call.
In a note released overnight by BofA’s Dan Suzuki tited “Back to bearish on small caps“, the bank’s equity strategist writes that with the failure to repeal Obamacare and the intensifying opposition to some of the key revenue raising policies of the Blueprint tax reform proposal (i.e. border adjustment taxes), there have been growing doubts on the probability of getting tax reform done this year.
As a result, while the bank still shares many of those same doubts, “we recently highlighted Policy as one of the three catalysts (along with Profits and Positioning) that could drive near-term small cap outperformance. On the back of the news around tax reform, the Russell 2000 closed at an all-time high yesterday, and small caps have returned nearly 19% (vs. 13% for large) since the election with 5% coming in just the last nine trading sessions (double the S&P 500).”
So what changed? In short BofA “thinks the small cap run is finally over.” Below are the key highlights on why BofA capitulates:
In our view, this last bout of optimism is likely to signal the end of the Trump Put, as friction arises over the funding the bill. Our economists recently made the case for why tax reform was likely to be smaller and later than the politicians have been communicating to the public. We now prefer large caps over both small caps and mid caps, and we see four key reasons to be cautious on small caps:
- Valuations: US equity market remains broadly expensive vs. history, with every size segment trading at double-digit premiums to their historical median valuations since 1985 on all five of our metrics. On forward P/E, small caps and mid-caps currently trade at the 98th percentile of their historical valuation range (since 1979) vs. the 87th percentile for large caps. Given that small caps now trade at Tech Bubble-like valuations, in our view it does not bode well for future long-term returns.
- Growth and confidence: The risk today is that, just as the Trump Put begins to fade, data could grow choppier. With positive economic surprises coming off of five-year highs, the math alone makes it difficult for data to accelerate from here. Already, second derivatives for various indicators are rolling over and measures of real activity are lackluster. Although small caps have less exposure to China than large caps, our EM strategy team’s recent view that peaking Chinese nominal growth will have negative implications for risk assets could weigh on small caps if investors begin to question the global growth trajectory.
- Credit: Small caps generally have a greater sensitivity to higher credit costs. High yield and investment grade spreads are within 35bp and 15bp of the lows for the cycle despite elevated levels of leverage, an increasingly hawkish Fed and pockets of stress within certain segments of the market.
- Volatility: The VIX has plummeted below 11, just as we see the big drivers of the rally beginning to lose steam. Indeed, our derivatives strategy team recently noted that several asset classes were pricing a “world almost free of risk.” There is a tendency for small caps to underperform when volatility picks up, and vice versa.
Judging by today’s market and/or reaction to BofA’s capitulation, the Trump put is still alive and very much well; either that or BofA’s note has still not been translated into binary for the benefit of the “traders.”