Investment thesis: With warning signs in credit markets and soaring gas prices, now is not the time to add micro caps.
Due to increasing data showing that active management works poorly over the long term, investors are now using ETFs as the backbone of most portfolios. These funds allow investors to target broad indices, such as the (IWC), which broadly tracks micro-cap stocks:
The iShares Micro-Cap ETF seeks to track the investment results of an index composed of US micro-cap stocks.
Here is the sector breakdown of the index:
And here are the 10 largest farms:
My standard analytical framework for ETFs is to first look at the macro backdrop of the index. Next, I compare the ETF’s performance to its peers. Finally, I look at the cards.
Since the IWC is a broad-based ETF, I will examine the macroeconomics using the long-term, long-term, and coincident indicator methodology developed by Arthur Burns and Geoffrey Moore of the Federal Reserve.
Liquidity is abundant, as shown by the sharp rise in M2 (left). But there was a sharp rise in the BBB yield (right).
Corporate earnings are strong. From Zacks:
The overall earnings picture has been very strong lately, with growth rates and absolute dollar totals at very high levels. The pace of growth slows significantly in the coming periods, as you can see in the chart below which gives an overview of earnings on a quarterly basis.
However, the overall pace should slow down:
The main indicators
New orders for durable consumer goods (left) are still at high rates and new orders for commercial equipment (right) are very strong.
Building permits for 1 dwelling (left) are rising again while wages (right) are rising modestly.
There was a slight rise in commercial paper rates (left). But initial jobless claims (right) are at low levels.
The gap between 10-year and 3-month Treasury bills is still wide. But the S&P 500 is in a downtrend.
Finally, the 10-year/2-year spread is tightening quite significantly.
Total payroll employment continues to grow at a healthy pace (left) while personal income minus transfer payments (right) is just off 5-year highs.
Industrial production (left) is increasing while retail sales (right) are still at high levels.
Economic conclusion: the overall picture remains solid. But there is some weakness in the financial indicators. The 10-2 yield spread has narrowed significantly, the stock market is selling off and commercial paper yields are rising.
And then we have the war in Ukraine, which caused oil prices and gas prices to skyrocket in the United States. The last time the price at the pump was at this level was just before the Great Recession of 2008-2009. James Hamilton noted that oil prices are a major cause of most post-World War II recessions. All this means that the geopolitical shock could cause a recession. But, I would expect it to be quite soft since all other indicators are still very strong.
Now let’s move on to the performance of the IWC by comparing it to the following peer group: IWM, IJH, QQQ, SPY, DIA, and OEF (seven in total):
|Week||Month||3 months||6 months||12 months|
|Relative performance of IWC||1st||1st||5th||7th||7th|
Data from Finviz.com
The CBI has been one of the worst performers over the long term. But it’s been the most successful lately.
Finally, let’s look at the charts.
The CBI has spent most of the last year consolidating sideways (left). The chart on the right shows that the ETF has fallen almost 20% since its highs last year.
Small caps need a growing economy with no potential recession in sight. While economic data is mostly supportive, there are potential problems in credit markets and now, on the foreign policy scene. Now is not the time to add micro caps to a portfolio.