What Can Save Micro-Cap Stocks?

 | Aug 24, 2017 | 5:00 PM EDT
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I had a long conversation over dinner this week with the CEO of a micro-cap company, and I sensed his frustration when the talk turned to his company's share price. 

In the midst of updating my numbers today, I looked at the performance of the Russell Microcap Index (RUMIC) on Google Finance. The RUMIC does not get much media attention, and the second news item for the index was a piece titled "Why the Big Boys Could Continue to Pummel the Little Guys" on Aug. 4 for Real Money. After my "hey, I wrote that" self-congratulatory pleasure abated, I realized that nothing has changed in 20 days and my premise for that particular column was still intact. 

Micro-caps have not done well in August and, in fact, the RUMIC has fallen 4.55% in the past 30 days vs. a 1.17% decline for the S&P 500 in that period. That confirms the year-to-date underperformance of smaller stocks as the RUMIC is down 0.63% thus far in 2017 vs. a 7.2% gain for the S&P 500. Even the more widely followed Russell 2000 Index -- really a mid-cap index, not a small-cap one -- has exhibited canine qualities this year, falling 4.5% in August and posting a paltry 1.05% gain year to date. 

So the questions have to be, as always, what is going to make this trading pattern change ... where is the inflection point ... how do we measure the second derivative? In the midst of a trading trend, it is just so darn hard to see it changing. But the profits are made when it does, and that is just as true in selling winners as it is in buying underperformers. 

The dominance of banks in the RUMIC -- financials compose 24.8% of the RUMIC-tracking Micro-Cap ETF (IWC) -- means there is one factor that could "save" micro-cap performance this year. Yes, it's my favorite indicator, the spread between the two-year and 10-year U.S. Treasury Notes. I manage to throw 2-10 spread references into almost all my conversations, and while my friends may wonder how that indicator is relevant in chats about the weather or the upcoming football season, I just cannot emphasize enough how important that spread is. It is the driving factor behind financial company profitability, and while JPMorgan (JPM) may have 75 other factors driving its earnings performance, small banks don't. The spread between the money spent to buy and hold deposits (short term) and the prices charged for loans (long term) is the key factor behind banks' net interest margin. That spread is clearly narrowing. 

I see the 2-10 spread quoted at 85.5 basis points on Bloomberg as I am writing this, and at the end of July the 2-10 spread was 96 basis points and at Dec. 30, 2017, it was 125 basis points. That is pure pressure on banks' profits, and that has been reflected in share price performance. The S&P Regional Banking ETF (KRE) , which tracks KBW's regional bank index, has declined 5.8% year to date, and that decline is hampering the performance of the RUMIC. There's clearly some group rotation at play, as the Financial Select Sector Fund (XLF) -- with a heavy weighting toward money center banks and brokerage behemoths -- has risen 6.5% thus far this year. That's more than 12 percentage points of outperformance, and it shows just how much the market values size these days. 

So, as the publisher of a newsletter called Microcap Guru, I have to call it like I see it: It's not a receptive market for smaller financial stocks and thus is a challenging time to be buying micro-caps in bulk. A shift in the 2-10 spread could pull the little guys out of their funk, but we are more than seven months into the Trump era, and so far the bond market has said "fuhgeddaboutit" to the idea of steepening economic expansion, which inevitably leads to a steepening of the yield curve. So, sadly, I am not expecting a micro-cap revival any time soon. In this environment, picking individual micro-cap names, as opposed to buying the group, is much more important than ever. Be careful when you do.

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