Market Caps: What to do at this stage of the cycle
Summary
We all know that some stocks are bigger than others. So for the sake of convenience, we today crudely will differentiate for you between "large caps" - the Goliaths - and the "small caps' - the Davids. What we want to do is to give you some guidance as to which caps to be out of at this stage of the Economic Time®.Topics Covered
- Fund management 101
- Why you want to be in smaller caps at this juncture
- How to make money off this idea
Background
1. Fund management 101
Traditional portfolio managers (PMs), those folks managing unit trusts, mutual funds and the likes, are VIPS: they greatly influence the direction of stock markets and particularly sectors within stock markets.
And they are mostly chickens. They prefer to emulate the contents of the benchmark against which their performance is being measured - as opposed to taking "good" investment decisions based on the merit of the individual stock concerned.
So when you buy a stock, beware of its size. As a simplistic rule of thumb: the larger it is, the bigger it will figure in the benchmark against which the PMis running his/her portfolio.
Take one Hong Kong and UK favourite, HSBC. It is a large cap stock. So it will feature big time in the indices which PMs benchmark their performance off.
Ultimately, for such PMs (and contrary to many hedge funds), the question of whether to buy or sell HSBC has nothing whatsoever to do with the stock's strengths or weaknesses. Instead, the question of whether to buy or sell HSBC has everything to do with its weighting in the benchmark index. If this weighting rises, PMs buy the stock; if it falls, PMs sell the stock.
Weightings don't change that much. One thing, however, that will change weightings, is when the market caps of stocks change. And one key way in which these change, in turn, is because they are bought and sold, depending on changes in the Economic Time®. Mathematically, then, the market cap of large caps = f(Economic Time,...).
2. Why you want to be in smaller caps at this juncture
As we have just pointed-out on India and on China (and thus on Hong Kong: "exit strategies" imply that particularly Central Banks want to change the Economic Time. Currently it is riddled with an excess supply of money, one that has fueled stupendous gains since last March. But the party is coming to a close: Central Banks want to create an excess demand for money in order to thwart inflation later on.
Readers know that we are less concerned about inflation in the West: high unemployment precludes consumer (discretionary) spending on limited budgets. But in Emerging Markets, a case can be made that there is an excess demand for goods, one that will fuel "demand-pull" inflation later on.
What does all of this economics have to do with whether to buy or sell small caps? Everything: they move less when the Economic Time worsens. That is because they are less liquid, so they are tougher to get out of.
Thus, when the Economic Time worsens in Emerging Markets in particular, you want to be in small caps as they will outperform the index. That is, of course, predicated on your having to be in the market in the first place. If you can get out of Emerging Markets, do so. I am just saying that if you still want/have to hang on, then go with small, illiquid caps.
3. How to Make Money Off This Idea
- Always consult your financial advisor first.
- If you must be in markets, then stick with the small caps: they are less liquid, so they will fall less during market convulsions.
- Short the large caps, particularly in Emerging Markets such as India, China and thus Hong Kong.
