There is an old saying on Wall Street that the markets climb a “Wall of Worry.” The past quarter and year certainly had several concerns, but the markets continued higher and finished the year at all-time highs. Some of these recent concerns were several Hurricanes. Hurricane Harvey came first, pummeling Houston on August 25th. Less than two weeks later, Irma battered the Caribbean and Florida. Jose and Maria followed shortly after, striking the Caribbean and crushing Puerto Rico’s infrastructure. The cost is estimated to be in the hundreds of billions of dollars and will take years to repair. The financial markets hardly noticed.

Hurricanes were not the only concern. There were political debates over health care, the debt ceiling, the National Football League and the Russian investigation. Then there were words raged between North Korea’s supreme leader Kim Jong Un and President Donald Trump. The belated announcement of a data breach at Equifax, potentially impacting nearly one in every two Americans, increased the already big concern about cybersecurity. How about all the Trump Twitter Tweets? It goes on and on. I think you get my point. The bottom line is that it seems that nothing will bring this market down, and it continues to climb that “Wall of Worry.”

Market Results

For the fourth quarter of 2017, large stocks continued to be the leader. The S&P 500 Index climbed more than 6% in the fourth quarter and rose by more than 20% for 2017. Smaller stocks performed well, but lagged their large cap brethren. The table above shows the performance results for the small/micro-cap indexes from Frank Russell & Company. During the past year, growth trumped value in both small-cap and micro-cap indexes. However, value outperformed growth within the micro-cap indexes in the fourth quarter. We are not sure if value’s leadership within micro-cap stocks is in a leadership reversal.

A deeper drive into the small/micro-cap universe shows that while the breadth was strong, it was not as strong as one might think given the gains last year. The table below shows the number of stocks that posted gains versus the number of stocks posting losses last year. Of the 3,244 publicly traded small/micro-cap stocks, 1,878 rose last year while 1,366 declined last year. A more interesting data point is that while the standard stock climbed nearly 15% last year, the median gain was only 5.51%. To us, the true standard company’s stock did not perform well last year. We believe there is a decent chance that the standard stock may do better in the future. Let’s look at several factors that could influence small/micro-cap stocks in 2018.

Interest Rates

Including yours truly, there have been many professional investors that have been forecasting higher interest rates for many years. The Federal Reserve spent the past year beginning the process of resetting short-term interest rates. Bond vigilantes may follow this year and reset yields. However, there have been several times in this recovery when bond yields attempted to rise only to be terminated and reversed. The obvious reason for this is that the U.S. economic data turned soft, but we think most of the blame came from other markets, which included Eurozone blowing up, China economy slowing, or various other global economic issues. This period, however, the U.S. recovery is broader, global recovery is more synchronized, confidence is stronger among businesses and individuals, and we are closer to full employment than ever.

The 10-year Treasury yield is currently just above 2.60%, which is up from 2.12% from July 2017 and 1.46% in June 2016. While inflation is still relatively low, it appears inflation is rising, and more importantly, inflation expectations appear to be on the rise. Should evidence support an increase in inflation, it should force yields to head even higher. Bonds have been in a bull market for more than 30 years, but given the current economic backdrop we believe the bond bull market is over. Even the charts support this theory. If you examine the long-term trend line of all the government bond yields, you will see most government bonds have broken their long-term trend line. The 30-year Treasury Bond is the only bond that has not broken the long-term trend line. We believe once the 30-year Treasury Bond breaks its long-term trend line, the bond market will officially enter a bear market. We have often said that rising interest rates are not a bad thing for smaller stocks. Smaller stocks have performed well in rising interest environments. Please refer to our white paper on Interest Rate Hikes and Small Cap Returns.

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