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  • Writer's pictureJan

The upcoming return of smallcaps?

The article is a quick summary of my conclusions and projections of how the economic and broad market conditions are likely to impact small-caps going forward, for the next 2 years. The summary of post would be: It might get darker but then it gets bright again.

This article is an extension of the prior posted article in 2022 on "the challenging situation" for equity and specifically small-caps market that we might face:

It is safe to say that since the publishing of that article in September and plenty of hints given the prior year to traders discussed on daily basis on the upcoming challenge for equity and smallcap market we are progressing as expected and outlined in the article above. Smallcaps have not seen any impressive volumes or activity since, and are likely to keep getting under reduction further on. More about that is in this article below.

Since mid last year as of publishing above article on the link I don't think that there is any doubt that activity and volumes in small-caps have shrunk and stayed in colder flows since then, and all the economic data and central banking policies suggest that what was said in the article is already happening broadly speaking.

But one thing on the article mentioned which is not yet happening to a high extent is- the staying power of smallcap traders getting weakened. We still see plenty of participation, which in my view over the next months could be reduced more than it was in entire 2022 as we approach closer to tighter liquidity conditions combined with the economic recession. The challenge of "nothing going on, nothing on my watchlist" type of small-caps markets is only yet to come for those trading it. But there is a larger opportunity following this period as well potentially.

The article is projection based but most of the conclusions made are not explained in depth, because the idea is to keep this article short and straight to the point, although whether the reader agrees with or trusts those conclusions is another story.

It isn't a secret that activity in small-caps is reduced. Many are noticing it. It is just that to see things clearly on the macro side and potential liquidity cycle projections are necessary to avoid quitting at the worst possible time, or fighting the wrong kind of market without having a realistic idea of how long things can remain cold.

It is never the fact that people have no idea that gets them in trouble in the market (as many are somewhat informed), it's the fact that they don't have a very clear idea and forward insight that causes trouble.

Meaning seeing things somewhat okay and recognizing that something is off is not good enough, that typically does not help enough to prevent one from trading too aggressively in the wrong kind of market environment. The main help on right expectations comes from understanding the cycles.

It is helpful to have the macro path outlined because that is what it takes to recognize when to reduce the "buy-buttons" buying power until the right time comes around. This is what this article's intent is to address briefly. The time for aggressive buy-buttons time will shine once more, but probably not before next 8-12 months, more about that lower on article.

The core outline that we are dealing with is that we are heading into a recession and possibly a liquidity crisis, which should impact small-cap equities. The pre-conditions already are affecting the market (2022 tightening) but the second portion of that which is the actual economic response and fallout to the tightening is only yet to come, and further impact the small-caps.

The main reason why is because of the correlation of smallcap liquidity/volumes to equities in general (SPY) and central banking policies has increased lately. Volumes have reduced from 2021 levels significantly and so has the number of strong cycles present. Let's expand on that more, below.

Smallcap performance in recessions and after

The image above highlights that institutional capital will reposition ahead of recession due to forward information often and push capital toward more resilient larger cap companies in advance of recession anticipation.

After the recession starts typically there is an inversion of central banking policies towards easing cycle and rate cuts, which brings more attractive risk-on conditions, especially once the recession is starting to be absorbed or getting into the rear mirror. This explains why equities often bottom out and then go into another rally right in the middle of depths of recession. However...this applies mostly to shorter duration, financial crisis enduced recessions, and not prolonged larger depression style crisis, which one might argue we might face.

The image above indeed highlights well why we have seen quite weak small-caps over the past year, meanwhile several large-cap stocks still get relatively better performance and most importantly higher liquidity (AMD, NVDA, AAPL etc).

This is why it's likely that over 2023 until we hit actual proper depths of recession (we are only at the start currently) or possibly a liquidity crisis event until then small caps will underperform, delivering low activity and liquidity, at least within context of 2020/21 style of market. The reduction amounts perhaps would/will not be that significant if compared to 2017 market for example.

The chart above suggests that then what follows is the inverse, the movement starts to pick up again for small-caps but to be kept in mind that is highly correlated to the central banking policy responses. To follow the above-average data, we would need to see central banks this time doing just what they did in all prior cases, which is to introduce rate cuts and an easing cycle (QE). This would then be stimulative to small-caps and create an opportunity environment.

It is key to understand that, the above data is only useful as reference if same sequence of events happens this time as it did in prior crisis events. This is not to say it wont or it cant, it just to highlight, for one to have right expectations keep eye on policy makers action if they are or are not following prior playbook, because that should impact your end-conclusions.

But we have to be careful with conclusions. First is that the image above collecting prior recessions only shows data within mostly global deflationary era present 1985-2020. So only the first 5 years of the 80s could count as an inflationary era, but the rest are mostly deflationary environment-related crises. This makes it somewhat different this time, as in deflationary global cycles central banks always have room to introduce easing cycles when things start to turn south in the economy. This does not hold to the same extent in inflationary cycles where their hands are more tied if they fear easing conditions might increase inflation.

Because of the point raised above from a practical standpoint what really will truly matter to come to the right conclusion for smallcap activity or what the central banking responses might be later this year or 2024, comes strictly down to inflation - CPI prints.

1. If we get a recession or crisis but CPI remains elevated we could see no significant easing cycle or QE.

2. If however, we get a large deflationary bust and CPI prints plunge right into deflation and perhaps negative as they did in 2020 then chances for a proper easing cycle in interest rates and QE implementation would be very high.

As equity traders, it goes without saying that scenario two is what we should really hope for.

It is because of that to make any solid projections for small-caps, we first need to see what kind of response in inflation or deflation will there be once crisis or recession deepens. This will then provide more clues on what is likely next from central bank policy responses because both of those roads have potentially very different results for equity markets.

-Recession-deflationary bust-followed by QE: equities positive (liquidity influx),

-Recession-sticky inflation-no QE or significant rate cuts: equities negative (liquidity drainage).

So keep eye on that CPI data, it will be key. Regardless if one is a large cap or small cap market participant same applies.

Market making ("pumping") of smallcaps doesnt really stop even when global markets are in trouble?

Market making activity is always required otherwise many smallcap companies would just get out of business or delisted from US equity markets.

Weak cycles with low liquid pumps are still likely to be present over next 12 months, followed by offerings. This means shorting opportunities are still to be around, but the range is smaller and RR is no longer as attractive. Shorting low % gapping tickers on low liquidity can be quite a challenge and mental hurdle (even if you think the ticker might fade 50%). This is why, if macro environment liquidity shrinks even further, sure the market making might still exist with opportunities, but those are providing lower returns. Stronger shorting/fade edge with much lower RR totals.

It is probably a valid point to raise that no matter how bad it gets the market making in smallcaps has to exist because that is lifeblood of listed-ability cycle for many smallcap stocks/companies in US markets.

Many of those companies are cash-burning machines, to keep them listed someone has to show up as a significant buyer to push the price up, hedge short, and then dump the offering to let the company stay afloat and listed. This might push one towards the conclusion that no matter what, there would be still pumps in small caps, regardless of general macro liquidity of broad markets. There is truth to that, but it gets more complicated if we dig more into it.

There are two points to raise: One is we don't have enough historical data to validate "MM/rigging of smallcaps has to be always present". Liquid smallcap markets have only been present for rather a short duration, for example, we don't have 250 years of prior significant recessionary environments in inflationary cycles to estimate how smallcaps perform in such conditions from market making activity specifically and overall liquidity. Majority of G8s economic or financial crises of the past 40 years were in a deflationary environment (more or less), to create correct projections I think that we need data from inflationary and de-globalization cycles specifically. But at those times smallcap markets, especially electronic ones with aggressive market making as exists today were not present at those historical cases. So actually, we do not have any significant prior data to lean on for firm conclusion.

On top of that as a second reason, sure the pumps might be around no matter what to let companies stay afloat but at what opportunity scale? If liquidity is weak and ranges get too tight it can be quite difficult to extract edge in small-caps. This is why liquidity is needed to create those range expansions and create the right kind of environment to trade that asset class. This is why 2021 was such a gift to smallcap traders. Liquidity and range. And tons of it. Now imagine the inverse of that and it just might start to paint a picture for 2023 where the central banking policy makers ("the liquidity gods") have started to worship a lord of demand destruction with all of their policies causing economic hardship, which is the opposite of 2021 conditions, from markets perspective especially.

It is true that to some extent smallcaps are operating within their own la-la land disconnected from broad markets to good extent, but the problem with such conclusion is that it is limited to only deflationary environment.

While we can assume that someone has to keep market-making small-caps in order to prevent those cash-burning companies to go under and cause an avalanche of de-listings on Nasdaq, there is some limitation on that assumption too: different macro environment. Its a long story to explain well, and probably we could conclude that it is true, no matter what MMs will keep pumping small-caps over the next two years even if the economy enters into a major slump, however, if the liquidity decreases and the ranges in tickers do as well (as it is common for weak cycles in small caps) this in fact would impact all traders in the space regardless if MM activity is still present, negatively.

To expand on argument, constant market making is necessary, as many of those companies and their stocks need it to remain listed and do their dilution cycles.

But what is required on top of that? Other market participants. Market makers by themselves cannot effectevily run this game just by themselves, someone actually has to get trapped on both sides of trades consistently in order to create enough liquidity for enough shares to be dumped and for MMs to effectevily hedge their long/short exposure to run stock both sides (pump and then dump). Which means its a chicken and the egg problem.

"Painting the tape"

The MMs create liquidity and "paint the price action", but to make it worthwhile creating the liquidity market participants are needed, else it isn't possible to create liquidity on a sustained basis without the liquidity creators suffering losses for creating one (who to sell against at high prices?) !

This is why the volumes in small-caps always scale proportionally to the number of participants entering the market and the amount of central banking excess liquidity created, it is all connected in a synchronized fashion.

It isn't a "chicken or the egg problem" as much as it is a closed loop. One can only exist with the help of the other, and vice versa. The point is...if we see a significant decline in market participation which is likely (if recession+liquidity crisis)...then liquidity and market-making should also decline for the next 12-16 months.

Whenever there is significant global liquidity tightening cycle (such as one present currently) with recession following, the result at the end is falloff from market participants. Loss of interest in trading, investing or anything dealing with markets in general.

Strangely enough that is also when best investing (catching market bottoms) opportunites also arrive, when most actually loose interest. And it is then also when best sustainable quick gains on long side of market can be made. But regardless of that, if there is drop-off from market participants, so is the drop-off of market making likely. But on upside new edges open up as well.

Therefore if market liquidity was to shrink (which it already has over past 12 months) much more over next year, we could see decrease in MM activites due to many market participants loosing interest to participate in markets. However keep in mind, this is only assumption as there is no significant pattern data from history to prove that, especially in regards to modern market-making or what one might call "price painting".

Because of that we might see decrease of "rigged" activites and opportunities for next 12 months.

However...there is light at the end of the tunnel, which is the QE. More about that lower on the article. It will just take churning though 12 months of desert to get to the other side of that green opportunity, because the QE cavalry will not come to the rescue before that in my view.

The most likely small-cap ignition: QE in 2024 (unlikely anything in 2023)

Let's go step by step. Why not to think 2023 has anything good stored for small-caps? This is because of the timing of how long it should take to step into deeper recession as of writting of this article (Q1 23) and potential liquidity issues in the banking and real estate sector, those are still cooking and likely to come into the front picture only within a few to several months from now on (personal estimation of course, could be wrong). It is safe to assume until all this initial stage unfolds, nothing too good can come about for smallcaps. So that is until Q3 as very unlikely of being stimulative for smallcaps or equities in general.

This means that a bearish equity environment is only yet in front of us if that was really to happen. Any central banking policy responses that would be highly stimulative and for the economy to absorb the initial shocks of recession would still take a few months after the actual epicenter of crisis/recession before bullish environment for equities would have a chance to happen.

This is why the timeline does not suggest we would see any easing policies in 2023 as likely (with exception of a few rate cuts which I don't think would be enough to stimulate equities).

This all moves the timeline forward to most likely being an early or mid 2024 case instead if at all. If we sequence potential events (with a good amount of humility as timing is very difficult for such things) then the more likely easing environment that would be bullish for equities has a chance to happen no sooner but in early 2024.

The key takeaway of this being is to conclude, it is not to time when next QE will happen as priority, but rather to define that chances of further low liquid environment in smallcaps are likely to remain until that happens. All of which from policy responses does seem likely as entire year from now on of prolonged weakness.

In markets it is always best to have realistic expectations as that extends your patience battery levels preventing one to make bad decisions in between!

Fixing deflation with QE injection

Now let's assume that is what happens, we get a deflationary crash just like the one we have seen in 2020 lockdown-style mode, with inflation prints going negative, and the central banks respond with the holy-grail fixing solution: quantitative easing aka QE.

This is where the fun in equities might begin, although it depends on many factors of just what kind of situation would be present at that time. But let's assume it wouldn't be too apocalyptic, and the market would be willing to bid up equities once QE gets implemented. If so this then opens up the window for large opportunities in smallcap equities once again, just as it was in 2021 but with a somewhat different flavor. Good but not as good.

Next QE is likely to be the best opportunity window that equity traders will get in a long while so squeeze out of it as much as possible.

The solution however becomes a new problem down the road potentially.

The sequence of potential events:

-To fix the deflationary crash introduce QE

-To fix the inflationary spike from QE introduce more rate tightening (late 2024, early 2025) and a new cold cycle for equities

The problem with introducing QE is that sure it can ignite a new buying frenzy in equities, but it could create another cycle of cold inactivity soon after that due to creating another set of inflationary issues to which central banks would have to respond with tightening.

This can create a situation where the FED would once again have to start hiking rates to combat a new wave of inflation, and therefore tighten the liquidity conditions in markets once more. Those sequences are not fictional, they already have happened as result in 2020-2023, and if we project the same type of response it wouldn't be too hard to imagine getting the same kind of sequence once again. Except for this time, with even more inflation, with even harsher economic conditions, and therefore even more negative impact on equities as prior deflationary buffers are gone. Perhaps for late 2024 and mid-2025.

6 months of QE paradise before inflation shows up?

The question would then be, if we assume the next big QE might happen as a result of a deflationary economic bust (CPI plunge from 6% down to 0%?) and central banks trying to solve that by injecting liquidity into banking and financial economy, then how long would it take before inflation would respond, triggering another round of rate hikes? This could give us insight into when next upward cycle in inflation might start, obviously assuming there are not some major additional reasons supporting its ignition such as geopolitical instability in certain regions, or otherwise.

For next two years we have structural issues present within the economy that are causing elevated inflation levels, such as:

-supply chain issues

-Chinas economic slowdown

-industrial decline in EU (Russian resources and high energy input)

-inflationary energy policies in the US


This means, that even with recession and potential financial crisis event looming which are highly deflationary the inflationary buffers might prevent the deflation to stick around for while. Therefore in CPI terms: We go down (2023) and then we go up again (2024-25).

Those issues no matter what happens over the next 3 years look like they will remain present to a good extent. The inflationary buffer floor is raised. So even if there is a short-term deflationary wave (just as it was in the 70s) that will likely bounce higher again shortly. If central banks respond with large QE that surely would speed up the bounce.

If inflationary buffers are high, and one has a quick deflationary bust, that means any introduction of QE in such a situation can quickly re-escalate inflationary pressures. This is why if there actually would be a large QE coming in my view we would see quick ignition of inflation back higher, and by quick in macro economic terms probably 6 months sounds reasonable before inflation would start to show up.

This leads to the conclusion that once that inflation starts to uptick fast, there might be a window around which the FED starts to think about another round of rate hikes to stop inflation from rising (once again in 2024/25, replication from 2022).

From time perspective we could think of it in this sequence for 2024:

1. QE gets implemented

2. Inflation shows up 6 months after

3. FED starts to think about new rate hikes

4. FED starts to hike rates 2-4 months after starting to think about it (think of January 2022-March 2022 as that reference in their dot-plots and policy responses)

Once new hikes start to get in the picture and markets realize we have another year of hiking cycle and replay of 2022 all over again, the QE paradise party might stop and equities would probably lose momentum. This is why I think that we might have a great opportunity longing or trading equities for around 6 months of that QE period which then will end abruptly and be gone for another year if not more once again.

But the timing of that would depend highly on how quickly the inflation would start to uptick. If fast, that would shorten the time window of equity bull market.

If slow uptick in inflation it would probably prolong the duration of bull market after /if central banks stimulate with QE and significant rate cuts.

It would also depend on structure of QE, would it be inflationary (2020) or more deflationary (2010) in its structure, depending on what asset classes would be bought by central banks. This would also matter on how quickly inflation would respond.

2021 craze all over again in 2024?

Would the opportunity be the same as in 2021? Not likely, because the interest rates would not drop low enough due to still present inflationary buffers (even if there is a short term deflationary plunge). Economic activity will also be probably tighter than it was in 2021 very likely based on all of the data coming out over the past several months, which makes the next QE environment not likely to be as bullish as it was in 2021, but it could have plenty similarities non the less to equity market movements. In short, it would be most likely the most significant window of quality opportunities in markets if and when if it happens over next entire 2-3 year period.

The path in 2023 is therefore likely to be just as bumpy as 2022, as all factors align to unlikely any changes to the bullish side of liquidity or activity presence in equity markets. But typically in all markets, the bear cycle always gets the darkest right at its turn, and its important to see things ahead if possible. Once the economic crisis or recession is well entrenched and potentially QE is implemented that could open the right kind of environment to be highly active in small-caps. That obviously assuming we dont have major banking issues down the road...

One thing that is worth noting is also the relationship between QE and inflation and why 2021 is such an important takeaway. It is one strange beast, the QEs, because there have been in past quite deflationary QEs, and recently we had much more inflationary QE.

QE by default does not have to be either inflationary or deflationary, because it depends on what asset class the central bank addresses under purchases, whether and are impacting monetary base expansion, and whether is it directed only towards bonds and equity purchases such as in 2010 US or 2015 EU, or are stimulus checks and monetary base also part of equitation, which changes the inflationary component that QE actually impacts.

Because of that, when we draw 2021 as outline, we have to first see what kind of exact economic situation will be present (lockdowns similarities and supply chain constraints) and what kind of QE will be implemented to project ahead to what extent we might get closer towards 2021 market movements, or perhaps something a bit different.

If we project forward based on conditions we have now and that might be present in the future, and especially if we assume a deflationary bust would be strong, it wouldn't be too much of a stretch to anticipate the next QE to be again inflationary just as 2020 one was, because policy makers will make it such (fixing deflation by creating inflation, and then fixing inflation by creating deflation once more, and repeat).

That if combined with a crunch on banking and supply chains remains present just as it was in 2020/21 which just might be because remember, why such a large inflationary spike was created in those two years is not just because of QE, but because of combination lockdowns and QE. Either one on their own is not very inflationary, but you merge them both together, and get what we got.

What QE?

But what if QE is not implemented somewhen down the road of 2024-ish?

What if there is a deflationary bust, but central banks are unwilling to provide liquidity to the market due to inflationary concerns? This scenario has potential, it should not be dismissed. That would be probably very bearish as it would prolong inactivity in equity space potentially for another year. Hopefully, this scenario does not resolute but it is good to keep it in mind as the potential to avoid surprises.

The above scenario suggests if we would get deflationary CPI prints but FED would found some reasons on why they do not want to create stimulus because of X and Y, whatever that might be. A realistic scenario in my view would be deflationary shock where supply chains or lending activity of banking freezes so much that it actually creates both deflation (consumer spending cut) and inflation (factory/productivity supply output reduction). That as combo effect could lead to decision of no significant stimulus by FED?

What about rate cuts, it isnt just about QE after all?

You might be wondering why mentioning just QE and not many rate cuts as part of the stimulative equation for equity markets. This is because it is unlikely that any deflationary-recession scenario would be able to lower interest rates from 6% down to 0% of what we have seen in 2021 (due to present long term inflation buffers). 6% down to 3% could happen for US but anything more is not likely, due to many reasons.

This is why the interest rates would not serve as key needed stimulus and the actual main more likely tool would be QE in such case. A 2-3% rate cut within a very challenging economic situation would not be enough to stimulate equity markets anywhere near 2021 scenario based on all the factors we see now or what might show up one year down the path.

Conclusion: Potential path

To summarize above for 2023/2024/2025:

-Recession this year: highly likely

-Financial crisis/liquidity event in Q2-Q4 23: likely

-Cold environment for small-caps until both of those events are absorbed by the market within 12 months: very likely

-QE (quantitative easing) following to invert deflationary bust of the economy: likely

-Very bullish environment for small-caps for 6 months of QE if it happens: very likely

-New central banking rate hiking cycle following due to inflation spike and the end of bullish environment for equities: likely

(red representing liquidity shrinking and green liquidity expanding environment). As traders or market participants one wants to see green conditions regardless of playing long or short side in smallcaps specifically.

Smallcap traders typically are not interested in macroeconomics too much, and for very good reason. Over the past 20 years, we were in a deflationary and globalization-expanding economy. This environment has allowed anyone to be dismissive of anything happening around you on the macro side because as long as "FEDs put" and liquidity pedal of 0% interest rates remained open, there was never enough friction in the liquidity environment for smallcap traders to care about things happening outside of their market.

It is safe to say those times are gone and we are moving into an environment where navigating close to actual liquidity and policy decisions of central banks on a half yearly basis has now become much more important as we move into more inflationary environment reinforced by de-globalization (likely entire 2020-30 decade).

This impacts the edge of market participants because one does not need to use the large bat to swing some good longs in the QE environment (everything just works) and on the other hand one needs a much quicker in-and-out approach on the long side when risk-off flows and the fear environment starts to ramp with QT instead of QE presence as liquidity just keeps flowing out of equity markets in general, including small caps.

Operating between those opposite dynamic conditions over the next 2 years will be key to recognizing shifts and pushing the pedal when the time is right, and pulling back when the opposite is the case. As mentioned in some prior articles, we will likely see 1970s inflationary (cold-war) era once again, rollercoasters in equity markets and economy, big inflationary waves followed by deflationary busts, followed by inflationary re-surge and repeat...This will impact the flows of equity markets with tap-on, tap-off behavior.


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