Macro Economics in a Micro-Cap World:
“Confident Trader’s” View of the Economy

I received a number of emails from our subscribers disputing my recent suggestion that investing in small- and micro-cap stocks takes you out of the realm of oil prices and Ukrainian wheat harvest figures.

Some readers took exception to this view, expressing their belief that the small- and micro-cap markets operate under the same principles as mid- and large-cap investment spheres. And, indeed, all public companies, regardless of size, do function under the same, immutable laws of economics, i.e. supply and demand. However, if all markets do, indeed, move to the beat of the same drum, how do you explain the discrepancies in YTD returns in various markets?

Take a look.

Different Market Deliver Different Results

Index YTD S&P 500 S&P MidCap 400 S&P SmallCap 600 Dow 30 Dow Transport Dow Utilities  -11.9% -3.9% -7.0% -16.09% 6.85% -10.2%

That’s a 9.9% swing between the Dow 30 and the S&P SmallCap Index. An even larger swing of 12.19% between the S&P MidCap and the large caps that make up the Dow – the index most self-directed follow as an indicator of market activity.

 

Those different performance figures aren’t happenstance. They reflect, not only the fundamentals and technicals, but market sentiment. And that’s where things start to fall apart. On July 24th, 2008, President George W. Bush gave a speech in which he advocated drilling for off-shore oil. What happened?

The price of oil dropped over $10 a barrel. Now, that oil Mr. Bush is simply talking about – no actual exploration or drilling activity taking place – is years and decades away from reaching your gas tank but the mere mention of a thumbs-up from the federal government drove down the price of oil.

There’re no facts to back up this movement in the price of oil. There’s no data, certainly no activity and Bush’s comments received a lackluster response from the oil giants who are fat and happy with things just as they are.

Climbing the Wall of Fear
There’s an old cliché in investing that markets climb “the wall of fear,” meaning that each day, investors must overcome their fears to take a position in a particular stock. “The wall” exists because in free markets, facts are not easy to come by but emotions are.

Fear is an emotion and when emotion enters your stock picking strategy you quickly lose perspective and sight of your long-term objectives. As we’ve seen the financials collapse, energy and health care costs rising and more intense global competition, investors become wary. Fearful. And for the market to continue an uptrend, investors must climb that wall of fear.

Macro Economics and Micro-Cap Performance
Which company is most likely to be hurt by macro economic trends – General Motors or a small biotech with 30 employees and product in the pipeline? Who will be hurt more by the weakening dollar? General Electric, a global conglomerate, or a specialty battery company with 90% of its business base in the U.S.?

It’s true that large-caps, mid-, small- and micro-caps operate within a single, world-wide economy, however, the data that drive large-caps is often clouded by trader emotion, aka market sentiment.

Small- and micro-cap investors can be less concerned about macro trends and whether the price of energy rises or falls. In fact, smart investors will look for ways to “play” higher energy prices by investing in a wind turbine micro. The long-term outlook for a well-run alternative energy company is brighter than it is for many blue chips – the market darlings in uptimes. The market scourge in down times, like we see today.

Notice I said “well-run” – something you can determine fairly quickly thanks to the web. Simply enter the company symbol or market sector and you’ll find all the data you need to conduct both a fundamental and technical analysis of the company stock’s current state and its prospects for the future.

Not All Small-Caps Are Immune From Macro Economics
This is both good and bad.

Let’s stick with the energy crisis as our example of a macro economic trend. Many oil and gas juniors are doing extremely well this year because of renewed market interest in new energy sources. Some of these publicly traded juniors have as few as six employees. They’re traded on smaller markets like the Toronto Venture Capital exchange (TSX Venture). However, macro economics have created boom times for these companies.

Conversely, a micro-cap manufacturer will most certainly see higher prices for raw materials, shipping, company health benefits and so on – all aspects of macro economic trends.

The key is to analyze macro trends and shrink them down into workable solutions or avenues of exploration. Alternative fuels will grow in importance. It’s a given with the U.S. currently importing 70% of its oil. Knowing this will lead you to prospects worth deeper analysis.

By deeper analysis I mean detailed due diligence on the part of the investor. Charts will give you part of the story but the prudent small – and micro-cap investor digs deeper, going over quarterly filings and a stack of prospectuses and annual reports with nice, glossy covers. The objective? A clear picture of how this stock picture is going to make you wealthier.

In this market, you can lose several times and recoup all of your losses and then some with insightful analysis on your part. I’ll take a 3845% annual return any day.

So, to provide some context, here, micros and small-caps may be impacted by macro economic trends, and some won’t survive because of global economics. However, the price of these smaller issues is more apt to be based on actual analysis without the emotions that drive larger markets.

Take another look at that chart of index averages YTD. One, the numbers don’t lie and they aren’t based on market sentiment. Two, there’s verifiable reasons for discrepancies in market performance. Small- and micro-caps are outperforming large caps in ’08.

So, shouldn’t some of your holdings be in markets less impacted by macro economics and more focused on actual company results rather than market perceptions or mis-perceptions.

Follow the numbers.