The Dividend Cafe - The DC Today - Wednesday, May 4, 2023

Episode Date: May 4, 2023

Today's Post - https://bahnsen.co/3VGvMUb A huge theme right now in market punditry is that small caps are under-performing big caps, and that this speaks more to macroeconomic reality than the fact that big-cap companies have mostly hung in there. As the reasoning goes, small-cap companies are more dependent on banks and financing and credit conditions and so struggle more than large-cap names in periods of fed tightening or bank distress. Of course, the corollary to this is that small caps underperforming going into a recession has always led to small caps out-performing coming out of a recession, but all of this is much more useful in hindsight than foresight. But I would say that I think small caps lagging large caps in periods like this is less related to credit conditions and more related to economic growth. Small cap names in the public sector are more tethered to revenue growth than big cap names, as big cap names have far more control over margins than small cap names do. Revenue is the most tethered to economic growth, and small cap names are more tethered to revenue. If we could look at an index of non-public small businesses, I would imagine it would reflect far more reliance on credit conditions (and of course, the economic cycle), but alas, such an index of non-public small businesses does not exist. But within the universe of publicly traded small cap names, my operating thesis is that revenue growth follows economic growth and big-cap names have more levers at their disposal to squeeze earnings out of slowing revenues than small cap names do. I have no idea when the cycle bottoms and when it turns, but I do know small-cap’s valuation relative to big-cap is looking quite interesting right about now. Take it for what it is worth. Links mentioned in this episode: TheDCToday.com DividendCafe.com TheBahnsenGroup.com

Welcome to the DC Today, your daily market synopsis of the Dividend Cafe, brought to you every Monday through Thursday to bring you up-to-date information and perspective on financial markets. Hello and welcome to the Thursday edition of DC Today. More drama and excitement in the markets today. in the markets today. I'm back in the Newport Beach office and I want to first make a broader point about something to do with small cap and big cap stocks and then I'll talk about today's actual market action. There's quite a bit of conversation right now about whether or not the big out performance of large cap to small cap, how small cap stocks are doing worse than larger capitalization companies in the public stock market is indicative of the credit issues, that there's less amount of credit flowing through and small cap companies need access to credit more and therefore they're doing worse than large cap companies. I think it's a fair summation, but I don't think it's fully accurate.

I think if we could index small businesses, family owned businesses, non-publicly traded, you know, small cap, meaning real small cap, like mom and pop family business, what we call kind of small business in our country. And you were to look at that indexed, which obviously can't do without price discovery and public trading of the values. But if you could, I think that that would look very constrained by essentially what has happened with credit conditions and financial conditions tightening. But within the small cap space of publicly traded companies, conditions tightening. But within the small cap space of publicly traded companies, I buy the argument that there may be some who are more capital dependent, although a lot of large cap companies are still very, have need great access to the capital markets, whether it's equity or

bonds or what have you. And so I do wonder if it has more to do with the growth cyclicality that effectively what I mean is when economic growth is slowing, you expect revenue to slow. Top line sales revenues will slow. That's a highly correlated set of metrics with top line revenue and economic growth. And yet small cap companies have less control over margins, less pricing power. So if revenues drop, earnings drop, where big cap companies relative to small cap have more control over margins and ability to manage either on the cost side or marginability, what will happen with those revenues so as to have it maintain a lesser effect in their profits. I think that's the case. I think small cap is more exposed, more levered to revenue growth than big cap. And revenue growth is more exposed to economic conditions.

I think that's a bigger aspect than credit conditions. Though, in the small cap indices, you do see a lot of these regional banks and community banks and smaller cap banks that are getting hammered. And that would be weighing on that aspect as well. What we do know is going into recession, small cap generally underperforms for the very reasons I've just cited. It's cyclicality to growth. And then coming out of a recession, small cap tends to do much, much better. Every recession I've studied and experienced, you know, as a professional investment manager, that there is a outperformance of small cap coming out of recession. So I don't have any words of wisdom about what kind of weighting someone wants

between small cap and large cap and trying to time what will happen in the market or the economy to what will happen with small cap. I just think that some of this sort of economic commentary as to how markets and why markets are behaving the way they are is important. The other thing I would say is just specific to today, that clearly this pain and distress in the regional bank world is not over. stress in the regional bank world is not over. And for those watching the news, Bank PacWest appears to be the next one on death's door, dropping another 50% today. It had been down 80% already or to date. They announced that they were looking at potential acquisition possibilities and raising capital and all that. And once you go to that mode, it just seems to be a matter of time to start circling the drain and we'll see

what happens with this particular bank. But that was definitely the pressure on markets today. Dow was down 286 points. It had been down a lot more. It did come back a little bit, but again, between yesterday and today, you now have seen a pretty sizable drop. And that is really related to this distress and uncertainty around the ongoing pressure in the regional banks. So yeah, the S&P down 72 basis points today, the NASDAQ down half a percent, the Dow down, as I mentioned, 286 points, which is 86 basis points. And then a really nice rally in the bond market.

One thing I will point out from a yield curve standpoint is a little bit of steepening that the 10-year was down three basis points. It's sitting at 3.37% on the 10-year, but you were down 16 basis points in the two-year. So a huge rally higher in the price of two-year bonds. So the bond market certainly is not worried about what the Fed's doing interest rates. I do not think it's the stock market worried about what the Fed's doing interest rates per se. I think that the market's concern about the Fed has to do with regional banks. And that becomes right now the current impediment to a little more market clarity and market opportunity. That is the scoop in the D.C. today.

Tomorrow, we'll be getting the unemployment report for the month of April. And the Dividend Cafe is going to deal with some economic truth. And it is worth your time. I'll see you tomorrow in the Dividend Cafe. Thank you. The Bonson Group and Hightower shall not in any way be liable for claims and make no express or implied representations or warranties as to the accuracy or completeness of the data and other information, or for statements or errors contained in or omissions from the obtained data and information referenced herein. The data and information are provided as of the date referenced. Such data and information are subject to change without notice. subject to change without notice. This document was created for informational purposes only. The opinions expressed are solely those of the Bonson Group and do not represent those of Hightower Advisors LLC or any of its affiliates.

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