When was the last time we had a normal year?
I’m looking solely at the stock market here. We can’t ever count on an ordinary year in life, because there are always unique joys and sorrows that make each year extraordinary.
When it comes to the market, though, COVID created conditions that made the last two years anything but ordinary. I’m sure you don’t need me to recall any examples.
Prior to that, in 2019, the Federal Reserve was beginning to reduce the size of its balance sheet. Quantitative easing, the process the Fed used to build up its balance sheet, began in 2009, in response to the crisis of 2008. Looking at a chart of the S&P since QE started, you can see that we’ve been subject to market returns that are anything but normal.
That seems to mean that 2007 was the last ordinary year for investors.
And in looking at that year specifically, we might get some clues on what to expect from the small-cap sector in 2022.
Fed Policy Directly Affects Small Caps
In the past few weeks, I’ve been studying 2007 — learning what worked and what didn’t in the last year before the market fell apart.
The chart below shows an indicator that identified every major trend that year.
This is a chart of the S&P Small Cap 600 Index. Red bars indicate times when the Fed balance sheet was contracting.
Even before QE, the Fed had a large impact on the stock market. The Fed managed its balance sheet to adjust interest rates and implement monetary policy.
Fed policy isn’t like a smooth drive down the highway. There are stops and starts. There are even times that look like reversals in policy. That’s because the Fed finetunes the money supply day by day.
There are seasonal factors that will force the Fed to add money even in a year like this when they are generally tightening. For example, the Fed generally adds money to the financial system before a three-day weekend to ensure that banks have sufficient liquidity and are able to meet the demand of customers who are taking short trips. This year, it might add less cash than usual ahead of Memorial Day. That’s still tightening.
To visualize the changes in the trends of Fed policy, in the chart above I used the 4-week rate of change in the balance sheet to quantify the policy.
Almost every significant move in the small-cap index was associated with changes in the balance sheet. When the balance sheet was expanding, stock prices went up. When the Fed was reducing its balance sheet, stock prices generally declined.
I focused on small caps because they should be the most responsive to changes in Fed policy. These are smaller companies that may depend more on bank loans than large companies will. When the Fed reduces its balance sheet, it decreases the money available for bank loans.
The chart shows that small caps do respond quickly to Fed policy.
Watch This Indicator Closely
This is an important thing to watch, given that small caps have flatlined over the past year even as the Fed balance sheet expanded. Now, with the Fed reducing its bond purchases and looking to raise interest rates, the impact on small caps will be telling.
I’ll be watching this indicator closely. If you’d like to monitor it on your own, it’s available for free in the Fed’s database. The name of the data series is “Assets: Total Assets: Total Assets (Less Eliminations from Consolidation): Wednesday Level.” As the name implies, it measures the balance sheet through Wednesday and is updated every Thursday.
With Fed Chairman Jerome Powell indicating the central bank is likely to change course this year, this could be the most valuable indicator to check every week.
And since we’re talking about small caps, it’s worth checking in on my 2022 prediction for a handpicked set of small caps to outperform.
The stocks as a group are so far down about 2.8% in 2022 — a little worse than IWM, down 2.4%, which is to be expected. One is up big — AEL, up 10.6% — offset by EXPO, which is down 10.8%.
But my thoughts haven’t changed about these stocks. I still like them as outperformers this year. Now is an ideal time to consider these stocks if you haven’t already.
Senior Analyst, True Options Masters
Chart of the Day:
Where’s My ATH?
We’re 12 days into 2022 and IWM isn’t at an all-time high yet? Oh, the humanity! I want my money back!
Yes, IWM is back at the bottom of its legendarily long trading range once again. And, once again, it bounced.
So, what now? An actual attempt at the $234 level? Or more sideways floundering to frustrate long-term investors and traders alike?
Well, if IWM is going to break out, you could hardly ask for better technical conditions to do so.
We see clear positive divergence on the momentum indicators, a bullish cross shaping up on the MACD after a little fakeout, and the price itself just put in a higher low at the bottom end of the range. Once the shorter-term averages catch up to the longer one, you have the recipe for an IWM rally that takes us to the top of the range and beyond.
Like Chad and Amber laid out in their 2022 predictions, I think you want to bet on small caps here. Short-term traders should bail if IWM closes a few days below the bottom yellow line, and look to take profits as we approach the top yellow line. It’s really that simple.
Managing Editor, True Options Masters