Small Caps Are Sounding The Alarm, Again

There is an ongoing tug of war between the monetary stimulus that has levitated financial markets and the economic reality that underpins them. When sentiment turns sour and risk asset prices fall in response to the gravitational pull of deteriorating market fundamentals, central bankers pull hard in the opposite direction with skillful wordplay that soothes investor concerns, sparking a price recovery. Janet Yellen has been masterful at convincing investors that while the US economy has near fully recovered and is on the right path for continued improvement, it is also too soon to begin withdrawing what is still crisis-level stimulus. Something is clearly amiss.

It has been my long-held view that the primary benefactors of the Fed’s stimulus have been the stock and bond markets, in turn leaving large segments of the US economy and American public behind. The result has been anemic levels of economic growth and headline numbers for the US economy that tell a far better story than the details behind them. Instead of allowing the markets to operate freely and discount sound improvements in the real economy as they occur, the Fed significantly influenced financial market prices through its liquidity injections and zero-interest-rate policy in hopes of achieving its desired economic outcome. This trickle-down monetary policy experiment has failed for the majority of those that it was advertised at its onset to help.

The reason that the Fed has been unwilling to normalize monetary policy in recent months is that it realizes its influence over financial markets is beginning to wane as the market fundamentals deteriorate. It fears that should it withdraw stimulus, risk asset prices will fall, exposing the fragility of the economic recovery and undermining its self-professed achievements to date. Regardless, financial markets have been slowly eroding from the bottom up for more than a year now. This erosion began in the credit markets when high-yield bond prices began to decline, and yields began to rise, during the summer of 2014…

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