Morgan Stanley’s Mike Wilson doesn’t sound especially enthusiastic about the historic rotation to small-caps.
A dramatic squeeze in beaten down cyclicality managed to grab a few headlines last week between wall-to-wall coverage of America’s domestic political melee.
The two stories aren’t entirely separate. Small-caps are an ostensible “Trump trade.” But if you ask Wilson, the business cycle will ultimately determine whether the trade has legs, not the election cycle. “While markets have been digesting the rising odds of a Trump win, cyclical upside from here will likely be dependent on growth,” he said Monday.
You can dive as deeply into Wilson’s latest as you like, but I’m not sure you need a deep-dive. He captured the gist of it pretty succinctly in the executive summary. Seismic small-cap outperformance was a “positioning-driven rotation, fueled in part by dealer demand and short covering,” catalyzed by expectations for rates relief (triggered by the favorable CPI release) and sharply higher odds of a Trump victory in November, Wilson said.
I’m happy to see Mike differentiate between the fuel and the catalyst. That’s critical when you’re assessing multi-standard deviation market events.
As the figure above shows, the six-session outperformance for small-caps was a statistical black swan. As in, it was unheard of.
The only time those kind of moves can be attributed solely (or even mostly) to a fundamental rethink is in the presence of world-changing events — e.g., the discovery of a vaccine for a pandemic. Otherwise, moves like that are positioning shakeouts: Something comes along and turns the trade against consensus positioning, things start moving in the “wrong” direction and it snowballs from there.
Anyway, Wilson suspects this particular avalanche is over. “While we’re respectful of still light sentiment/positioning in small-caps, we see limited fundamental and macro justification for small-cap outperformance continuing in a durable manner,” he wrote.
The table on the left, above, shows forward returns following instances of outsized small-cap outperformance. The figure on the right is straightfoward: If you’re into lines, small-caps’ relative performance just hit a ceiling.
“The cohort has historically underperformed following tactical rallies, and its relative performance versus large-caps is now facing technical resistance,” Wilson went on, adding that investors drawing a parallel to 2016 would do well to note that “relative earnings revisions for small-cap cyclicals are much weaker today than they were during that period.”
Long story short (no pun intended), Wilson said “cyclical upside from here will likely be dependent on growth.” In a late-cycle environment, quality outperforms.
