Avoid Small Cap Stocks

Investors,

My latest analysis about the Dow Jones vs. Treasuries seemed to ruffle some feathers, so I’m here to double-down by analyzing utility stocks vs. Treasuries (XLU/TLT):

While this ratio chart is not currently trading at all-time highs, it’s rapidly accelerating towards the peak achieved in 2022. Utility stocks are largely viewed as the most defensive stock market sector, given their consistent cash flows, high dividends, and recession-proof business models. Therefore, the goal of this analysis is to compare one defensive asset (utilities) vs. another (Treasuries) in order to gauge risk appetite.

When this ratio chart is rising, it means that even the most defensive segment of the stock market is outperforming U.S. Treasuries. This is common during periods when the stock market is doing well, the economy is chugging along, and there is plenty of appetite for risk.

When this ratio chart is falling, it means that Treasuries are outperforming utility stocks. When investors have more demand for Treasuries (largely viewed as the apex defensive asset, aside from cash) than utility stocks, it’s likely true that there’s a significant amount of uncertainty in the market and investors are looking to escape that uncertainty. As such, Treasuries outperform utility stocks during periods of economic turmoil, like recessions or financial crises.

At the most basic level, the following conclusions are valid:

• XLU/TLT rises when times are good.

• XLU/TLTL falls when times are bad.

While this is perhaps an oversimplification (the investment environment shouldn’t be classified by one simple variable/relationship), I think it’s a fairly accurate rule of thumb!

Broadly speaking, XLU/TLT has been rising since the Great Recession, during one of the greatest bull markets in history. The February 2020 reaction to COVID was a clear risk-off environment, where investors had no appetite for utility stocks and were running for safety in Treasuries. Once the dust settled and the monetary bazooka of the Fed’s QE program was launched, investor appetite for risk returned and the stock market boomed once again. During this period, from March 2020 through January 2022, XLU/TLT was rising.

It gets tricky when we evaluate calendar year 2022 because this was objectively a bad year for owning equities… Each of the U.S. indexes entered bear markets during the year and had severe double-digit percent declines. However, XLU/TLT was rising during 2022, arguably faster than ever! This forces us to ask, “was the strength in XLU/TLT telling us that brighter days were around the corner?”

Given the strength of the market in 2023, I think this is a valid hypothesis. It’s something to think about and I won’t be bold enough to say that I have the answer. All that I do know is that XLU/TLT is still rising today, which leads me to believe that the market remains strong enough to have a bullish bias. With a defensive asset outperforming an even more defensive asset, we can conclude that risk assets are doing well in this market environment. Therefore, because equities are broadly speaking considered to be risk assets, this ratio of XLU/TLT suggests that risk assets have tailwinds to rise.

In the remainder of this report, which is exclusive for monthly/annual members, I’ll be discussing the following market topics:

• S&P 500 internal metrics & under-the-hood conclusions

• Why I think that small caps should be avoided at all costs

• Valuation dynamics in the current market environment

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