Keepers

In sportfishing, certain types of fish are deemed keepers. Ones that are not too big (the prime 'breeders') - or too small - not worth the effort to clean them. As I posited last week, this is a great time to be bottom fishing in the market. Just be sure that you are 'keeping' the right stocks in your portfolio.

The too-small fish are the smaller companies that have yet to achieve a self-sustaining level of profitability. They are capital starved and less likely to withstand an economic downturn. With the Tuesat11 Risk Aversion Indicator at 11, (below), there is a buyer's strike on most of these embryonic start-ups and junior companies.

Risk Aversion Indicator

Image : Vivendi Pictures -Spinal Tap

And the mega-cap darlings of the past cycle, such as Apple and Microsoft, are likely going nowhere for the next few years. They are now too big to out-grow the economy and will 'spawn' investment flows into higher-growth and inflation-proof alternatives. They will be sources of cash in the next cycle, succumbing to higher discount rates and resultant compressed valuations.

The sweet spot is the midcap space with many seasoned businesses that are cheap, high-quality companies with clean balance sheets and growing market shares. You can see this effect in the outperformance of the S&P Mid-cap Index versus the large-cap equivalent (below). These stocks have stopped 'under-performing' and look to be 'breaking out' again.

S&P Midcap vs Largecap

The rationale for this is two-fold. They are cheaper than the market and they are more likely to grow faster than the slowing economy, especially if they are gaining market share from larger slow-footed incumbents.

In a scarce labour market environment, and with market-based compensation disappointing, smaller companies are able to offer attractive upside to employees looking to make a move. Think of Schumpter's creative destruction theory for validation. And, with a still-harsh economic environment yet to come, there will be plenty of destruction to go around over the next year or so.

So the bad news for the likes of Peloton and Facebook, will be good news for smaller more nimble entrants who are hoovering up the talent being callously shed by those fading franchises. This is just another reason I believe that the stock market - especially the average stock - will do better than the economy next year. I postulated the reverse in my 2022 forecast and that now seems to have played out.

The equal-weighted S&P should continue to do better than the cap-weighted version (below). So stop obsessing about the 'market' and start accumulating good companies at cheap prices!!

Equal-weighted vs Cap-weighted S&P 500

An inevitable decline in inflated multiples is another argument that small is beautiful. Those with strong financial quality and below-market pe's should fare better than the past favourites that are still over-owned. Apple's 21 PE seems a bit aspirational still.

Have another look at midsize companies to find some 'keepers' for your portfolio stringer over the next few months. And like fishing, you also need to be patient. Given all the unknowns (who saw Gilts blowing up ?), the bottom you pick may end up being your own.

Risk Model: 1/5 - Risk Off

Last week's 'too hot' employment data truncated a bounce that was based more on the hope of a Fed pivot than anything else. There is certainly bad news coming, given the global deceleration and inverted yield curve. But it will likely not show up in employment for a few more months, especially going into the twin retail frenzies of Black Friday and Christmas. So with the Fed's eyes firmly on this trailing metric, it becomes increasingly (and depressingly) obvious that we are in for a hard landing in early 2023.

The sentiment chart below is bumping along the bottom like a fishing lure. Don't look for that to change quickly, as there is self-fulfilling nature to most bear markets. Signs of capitulation are starting to show in the fund flows that are now heavily tilted to cash-equivalent, short-duration fixed income for the first time this year. A Vix spike would be a good signpost as I pointed out a few weeks back. That possibility looks to be back on the table now that the coincident data for both jobs and CPI are staying stubbornly high and the Fed so intransigently hawkish.

AAII Bull/Bear Ratio