Markets

What's Ailing Wall Street? You've Known for Years...

"Uncertainty is the worst of all evils until the moment when reality makes us regret uncertainty." - Jean-Baptist Alphonse Karr (1808 - 1890)

The French novelist Alphonse Karr had another apropos quote, "Plus ça change, plus c'est la même chose." Translated this means, 'The more things change the more they stay the same'.

How do his words fit my message today?

According to the Congressional Research Service, the debt ceiling has now been raised 75 times since 1962.

So what's new about this time, if anything, and why has the world all of the sudden become fascinated with the so called debt ceiling?

The answer is found in my first quote above; reality. Wall Street is now facing the reality that growing debt in the developed world is a significant constraint to growth. This reality was swept under the rug as quantitative easing fueled a two year market rally - but has crawled out over the past couple of weeks.

Now reality has taken the shape of a lurching bear running around Wall Street knocking stock prices down.

As the U.S. government takes steps to control spending, according to its recent deal, some economists believe GDP will falter. U.S. GDP in the first quarter was a paltry 0.4 percent, and just 1.3 percent in the second quarter.

If GDP slows any further, future deficit reduction plans become less likely since revenues will drop, making it harder to reduce spending.

By the way, the debt ceiling is a fictional 'line in the sand' that is equally shifty, as evidenced by the number of times it has been raised over the last 49 years. Do the math, you'll see that the debt ceiling has been raised an average of 1.5 times per year since 1962 .

A more appropriate term would be 'debt sky', to reflect the reality that there is no limit whatsoever to what the U.S. is willing to borrow.

The chart of the U.S Debt Limit below, courtesy of The Heritage Foundation , compiles data from the Congressional Research Service and the White House Office of Management and Budget.

Package all of the above into a mid-summer market lull, coupled with weak economic data and you have a potent mix.

But really, almost everybody was aware of this problem all along. It is just a matter of when it was going to come up, and how the market would deal with it.

The debt ceiling debate became a convenient excuse that attracted the world's attention and turned the focus to hard issues - those that would actually result in a balanced budget here in the U.S.

The plan in Washington now is to push major decisions back yet again, consider another round of quantitative easing, and see where that gets us. In other words, "Plus ça change, plus c'est la même chose."

How Do Small Cap Investors Deal?

Given that much of the above was already known, our game plan is not significantly different than it has been.

Small cap stocks tend to outperform over the long-term, and targeted strategies that focus on stronger sectors over weaker ones (as opposed to a broad index like the Russell 2000 Small Cap Index) can significantly outperform the market.

On Tuesday, a day when the Russell Small Cap Index lost 3.5 percent, our Small Cap Investor PRO portfolio closed down just an average of .8 percent. This is a perfect example of the benefits of targeted diversification in a portfolio - the goal being to capture outsized gains to the upside and limit losses to the downside.

The chart below shows the Russell 2000 versus the S&P 500 since 2000, and the message for small cap investors is beyond compelling - a 53 percent gain in small caps versus a 14.2 percent loss in the S&P 500. Note that this time frame encompasses the dot.com bust and the 2008 market melt-down, so it's not a simply a window showing the glory days for small companies.

To show how our portfolio stacks up I recently ran a comparative analysis to look at the return of each of our positions since their recommendation date versus the return of the Russell 2000 over the exact same period. The end result was that our average gain is 29 percentage points above that of the benchmark Russell index.

So to sum it all up, my message today it this - over the long term small cap index investors can do extremely well, and a targeted strategy can do even better.

Don't be surprised that the market is behaving the way it is because the looming issues of debt being a burden on growth was known. It was simply pushed out of investors' minds.

Despite the market's bearish behavior, it is still possible to make money as a small cap investor if you stick to a clear and steady strategy of allocating capital to strong sectors of the market, and avoiding weak ones.

Right now, that means continuing to buy and hold gold and silver since as long as debt levels keep going up so too will these assets. Also focus on companies with exposure to global growth trends. It is critical to recognize that these trends may be markedly different from domestic growth trends.

Three examples are in precious metals, oil services and mobile technologies, all of which are enjoying growing demand from developed, developing, and as of yet, undeveloped nations.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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