Hey, it’s getting dry out there.

This article intends to create a summary of the situation we have had in small-caps over the past 12 months and highlight how the worsening of macro conditions in the global economy are potentially impacting small-caps in a significant manner by now. Even though the situation in a broad economy already worsened in 2022, it took an additional year before this is reflected in most large caps and small caps due to the lag effect of those changes being absorbed into companies.

15 years of very low-interest rates followed by a major change

Even if one is an experienced trader with a decade of smallcap trading or investing experience, it is likely that the changes in small-caps happening currently are seen for the first time as over the past 15 years. The low-interest rates and quantitative easing enabled small-caps to get traction and that situation has for the first time changed to a significant degree.

This means that it’s hard to use recent historical data of small-caps to do projections or to anticipate the current dry slump we have seen because the prior 15 years have been different on the macro situation side.

It is in my view one of those situations where to anticipate the dry market ahead in smallcaps one had to have done projection based on assumption and market mechanisms that make sense rather than using recent historical data to guide projections. Especially since more than 15 years ago, small-caps were quite a lot different as a market which makes very historical data (50 years for example) not very reliable currently.

Because of that when I was talking to many experienced traders last year about the potential worsening of smallcap markets it caught no traction or interest from most of those individuals seriously, as most traders are thought to look back to find the answers, but that back in current situation provided no context. Mostly because smallcaps as they exist (highly manipulated dilution driven) are relatively new.

And how does one look back, when the last time we had an inflationary tough macro environment was the 1970s with very different (and much less liquid) small-caps (and a low amount of advanced tech sectors)?

The projection had to be extrapolated through the knowledge of how markets operate, which is why so many experienced traders completely underestimated the change in small caps for the simple reason: Most smallcap traders (including experienced ones) are not well trained in overall market knowledge, they are highly focused on smallcaps themselves only.

Many large cap stocks in interest rate sensitive sectors (real estate, solar energy, weed…) came under more difficult environment due to tougher macro situation. This leads to stocks of those companies underperforming as we have seen in the past one and half year. The reason why this matters so much is the impact that the underperformance of LC leading tickers leaves on small-caps is that it decreases the chances of stronger moves and frequency of moves if those large cap sectors are underperforming across too many sectors at once (not just one sector that is struggling).

Typically in the background when certain smallcap tickers are popping up in pre-market scans often in such situations there is one decent performing large cap ticker of such a sector that has relatively good performance.

By the way, this isn’t meant “hot sector” necessarily as the term i used often on prior articles. It is meant just in general any sector that has relatively positive performance but that performance does not need to be explosive or catching much of media attention as it would in typical “hot sector” play.

For example ideally for smallcaps there should be decently upside-moving solar sector stock (a few of the biggest ones) in the large cap side to increase the chances that some tickers in small caps within solar sector then get attention and possible PRs. Meaning that its not a must to have explosive upside moving solar large cap stock to get smallcaps moving, what needs to be met as basic condition is just to have it perform with positive/green month-on-month performance. This really helps chances to get some PRs and pre market squeezes on some of sector related tickers.

Monopolization of market is not good for smallcap performance

The reason for outlining above is just because SPY is “up” is not a good enough reason for small-caps to get traction. We can see this over past few months where SPY is in uptrend but smallcaps are really struggling. What needs to be also present is that multiple sectors in the SPY component need at least one or two higher cap names that are currently in an up trend. Which actually means that within SPY index there must not be monopolization present where 5 stocks within entire index do most of the lifting on the positive performance of equites.

A conceptual example of an ideal vs non-ideal situation:

Recently over the past year, we have seen that SPY is holding well but mostly because just a small fraction of stocks within the SPY component have really been performing well. Many sectors and a big chunk of stocks within the index had actually completely flat or red YoY performance.

Such situation is not ideal for small-caps, because it reduces the chances that all these broad sectors in small-caps have a lesser chance to move, and only maybe one or two sectors are on the potential list (as we have seen AI in April).

It explains partially why both Russell 2000 and SPY should be in an uptrend (and Russell has been struggling a lot), along with sub-component sectors of SPY need to have balanced positive performance too, rather than just having 20 biggest stocks in SPY that do all the lifting. Which is pretty much where we have been so far lately.

Bull markets hide mistakes and what trully drives each market

Traders in small-caps tend to miss this part and don’t pay attention to broad markets too much and how they impact smallcap movements. And the reason why not is because we have been spoiled by the multi-years of just continuous positive performance of a large spectrum of equities on the large cap side.

This makes traders pay less attention to what’s happening in large caps when it comes to assuming how much of “hotness” there might be in small caps. But eventually, when the macro situation and conditions toughens the attention is highlighted (people start paying closer attention).

This effect is very visible in crypto and the relationship of the 10 biggest cryptos and the footprint of squeeze chances they leave to altcoin assets. Traders in bull markets of crypto trade altcoins as if they are their asset class and competition to Bitcoin or perhaps disconnected to a large degree from other large-cap tickers in the crypto space. And you only realize how much this is not true once the bear market kicks in. The same is true for small-caps.

Just as within the crypto space to ignite altcoins in the De-fi space you need leading two assets to be performing in a positive trend, the same is true to a degree in small-caps to have something moving in the solar energy sector for example, there should be some large-cap solar stock that has been doing alright. As said before do not confuse this with “hot sector” which is typically meant for real media frenzy (something like AI). This is a much broader picture that needs to be there for the daily operations of pumps and dumps in smallcaps to function normally.

Using solar energy as one example, when the interest rates rise as they did over the past two years, certain sectors in large caps become very sensitive to that (solar energy being one good candidate for that), due to the sheer amount of debt that those companies need to take on in large caps to finance their operation. There are a bunch of sectors in SPY or large caps in general that are very sensitive to poor macro environment (and have huge debt loads) and there are a few sectors that are less sensitive. As result those very sensitive sectors will see large cap stocks underperform and possibly go into bear trends as seen with NEE for example:

What happens, as a result, is that this seriously limits the capacity of small-caps that are within the same sector to ignite or to get attention. Because if large caps are tanking or not performing with green MoM performance, there is a much lower chance market makers would be touching small caps within the same sector.

Now compound the problem explained above across multiple sensitive sectors in large caps that share similar recent poor yearly performance as some solar stocks above, and that explains why there is a cutoff in action for smallcaps. Again this does not explain it all but it definitely is one of the foundation pieces.

It all goes from the top down. If you want to thrive on the bottom down there (which is what small-caps are) you need the help from those up there, the large caps, and its not the help of LCs that we are looking for but the help of central banks and stimulative policies. Their policies are what drive the performance of large caps in the first place.

It’s important to highlight this because as outlined above, traders do ignore this factor as long as the general/broad bull market is still alive. In bull markets, much of the mechanisms of what drives markets are hidden. This is why people get obsessed with things like WSB which has nothing to do with long-term sustainable edges of smallcaps or what is causing the pumps in most cases.

To thrive in small-caps we don’t need WSB and many other pump groups, what is necessary is to have supportive monetary policies from central banks in place and overall decent performance across multiple sectors in large caps.

Multiple sectors, let’s highlight that point. To understand why 2021 created such a frenzy you have to look at sector performances across the board and notice that a huge amount of sectors were doing fine, unlike for example 2018 when that number was quite noticeably lower.

Multiple green sectors work as multiplier effects. The amount of potential smallcap tickers that can come into play and get driven by market makers increases significantly when there is more than just one or two decent performing sectors in large caps. The ideal situation is when everything in large caps is green. This brings us to what are the worst possible conditions. When too many sectors in large caps are red on performance or especially their main leading tickers. This creates a division effect and cuts the potential tickers in the play of small caps by the same amount.

It’s probably worthy outlining above because some are trained to see markets this way and this will all be very logical. In fact, to the majority it probably is. But what happens as mentioned above bull markets spoil the traders, to the point where this effect is no longer being tracked by many. The whole focus of the smallcap trading becomes just about checking what is hot in pre-market and moving and then creating plans around the current stock in play. And the more days that pass like that, the more zoned traders become disconnected from whats happening in large caps or especially the broad economy and macro environment. Bear markets or dry markets will highlight just how much this is true, always true. All markets are connected and correlated between each other, or with other words all asset classes compete with each other. In bull markets people just dont notice that, because everything gets a bid. When things get tough, something gets bid and something else gets a sell.

Eventually everyone gets it but its the time on how fast you get it is what matters, because being late is not great for trading or investing.

When small caps shift into a dry market for a year for example, in hindsight it doesn’t take rocket science to reverse engineer why it is happening. But if you don’t know this in advance, you have already probably dug a hole in your trading account for not paying attention to that early on.

Recognizing macro environment changes and cycle changes needs to be done on time to prevent doing damage and forcing low-quality trades when the environment is just not there, especially….the long side.

The guys on the long side will do most of such damage, typically traders on the short side get bored due to lack of opportunity but the long side is where you can dig a hole if the above dynamic is not noticed early on in the cycle. And by the way, early on is not now or in August, it’s well back into mid-2022 when the change in the macro situation becomes already completely obvious if you know what to pay attention to.

Get those offerings done fast before it is too late

Back in 2022, I believed that because the macro situation was going to worsen, many placement agents that run dilution campaigns for smallcap companies and SC companies themselves would do a quick burst of offerings before the situation in broad markets worsens to the point where large caps no longer provide positive buffers and therefore decrease the attractiveness of small-caps.

Because when that happens, it gets tougher to do pump and dumps and dilution games.

This loop of the game in small-caps becomes harder to execute, which explains partially the dryness:

The quicker the tickers drop over 6 month period and the fewer large-cap sectors are being positive, the fewer PRs with new “hot” projects are going to come up for small-caps, and the fewer pumps those companies are able to do. This in effect pushes stock prices low without the ability to pump and dilute, plus it worsens the attractiveness of the sector because “interesting” PRs or projects are no longer being announced. Fewer PRs, fewer pumps, less new dilution ability (old dilution is still exercised), quicker price declines, and in summary this means that any new offerings have to be done at very low prices with smaller dollar amounts (because amount of capital extracted through offering is typically correlated to stock price over long run) that companies can extract from dilution (unless you really want to get delisted quickly from Nasdaq).

Pump and dumps and dilution games are your friend, regardless if you are short or long-biased

Regardless of which side you trade small-caps and how you wish to extract the edge, the typical sequence of dirty smallcap games is required to maximize edge:

-get something moving in large caps

-release PR in smallcap ticker

-run a pump (by market makers)

-dump (leading market makers hedge short for offering)

-offering is announced (pre-coordinated with company and PR in some cases)

-unwind of tickers price

-reverse split

-repeat

Theoretically one can still trade smallcaps without the above scheme taking place, but the word used above was “edge maximization”. This means that without this game being constantly in-play the RR and opportunity frequency will decline. Sure one can still swing trade the long or short but especially the long side of swing trading small-caps in such cases becomes much more difficult. Without a high frequency of pumps (and PRs), the smallcaps by a large degree are tilted into bleed mode over a 1-6 month horizon (even without aggressive dilution). This means that longing for investors or swing traders (or yolo gamblers looking for the next 1000% runner) is going to become more problematic and eventually lead to a decline in interest. Less long-term demand. Fewer pumps, and less long-term demand, therefore less ability to dilute and higher chances that those companies might get delisted or bankrupt. This effect explains why in such a situation as we are facing in 2022 so many tickers become priced under 1,00 USD, many of which companies in the past 5 years have on average traded above 2,00 or even 3,00 USD average price (obviously nonreverse split-adjusted).

Long-term impact of less dilution or less bigger-sized offerings

Since many smallcap companies are high cash-burning vehicles, when companies’ share prices decline too low and the efficiency of extracting dilution is decreased due to problematic macro situations few solutions can be implemented by the company’s leadership, none of which are ideal for long-term prospects of stock price. Mostly because they involve cutting operations, reducing expenses, and shrinking down projects in the pipeline.

For markets to have interest in those companies, they need to bring a big punch of excitment. Meaning, something new and promising, which usually means loading up big projects that are expensive (even if execution chances are low).

We have a market as of currently where companies are forced to inverse on that (to some extent) and go into more humble mode by slowly shrinking operations (because offerings are reduced in size due to too low share price or lesser offerings in general due to no pumps) that is not ideal. Who wants to be buying smallcap equities with high risk where the reward is humble and nothing exciting because companies have difficulties raising cash and are shrinking operations? That explains why in such cases the capital outflows go from smallcaps into large caps where there is humble rationing going on but at least the risk is much much lower. In simple terms, small-caps are no longer as competitive.

What a high-interest rates environment with poor global economic conditions does is it changes the competitiveness of market assets. It starts to reshuffle attention from one asset class to another, and the effect is the inverse pyramid. If you think about it, in bull markets the flows go from the top of the pyramid down to the bottom (where small-caps are).

In dry or bear markets the flows inverse and start to flow from the bottom side to the upper side of the pyramid, basically contracting down bellow, and flight to safety to higher levels of the pyramid and higher quality assets. We can use 2021 and 2023 as two opposite years. The first one was where flows were going from top down and the second year was an example of the inverse.

To inverse the pyramid flows therefore what we need is…

Briefly speaking we beed better monetary conditions with lower interest rates, recession being priced in and behind us, and large caps finally across a large spectrum of sectors creating positive performances. None of that is currently present and the market has been pricing in over the past year those negative changes.

Is it priced in by now, by a large degree?

Markets will price in changes in advance. So the question becomes has it all been priced in? I don’t think so. Especially not if the financial crisis would happen during the current recession (most recessions have financial crisis going along with it). There is more to come, the question is just how much more and what timeline we still have to go through. Realistically it could be a year before things are priced in well. But don’t hold me to my word, I am using this timeline with crude assumption as there are too many dynamic variables that could change to shrink or expand that length.

The second scenario is if all stocks are crushed significantly over the recession or financial crisis and their valuations are brought much lower, that could create then better environment for smallcaps to have chances of movement, as from lower prices large caps have better chances of creating positive performance and therefore helping smallcaps in action. So heavy unwind of SPY or large caps could provide in the future (a year after that happens) a possible scenario for more small-caps actions.

Much about required easing monetary conditions and QE and how this could positively impact small-caps has already been explained in the prior article if you check it out.

Result: more cheap tickers with low volatility

As outlined before, this all leads to creating more tickers with low prices, especially around or under 1,00 USD. Those tickers are less rewarding and especially less enjoyable to trade for those that trade intraday. Sure the ticker might be squeezing on 100% from 0.5 to 1,00 USD but the actual range on 15 minute basis is no more than 10 cents. This makes it hard to rotate the position or recycle because it might not be worth it, once commissions and mistakes are added on top.

Because of that in my view, it’s better to adjust specifically for such tickers with slight changes in trading approach to address that. Such as:

-lesser position size but wider stop,

-aiming for ADFs more often than previously (due to weaker overall demand) therefore increasing patience on short trades,

-decreasing the amount of long trades, etc…

Also, do not underestimate the commission aspect change. When trading very cheap tickers on low volatility, the commission impacts for most traders rise. This means any recycling done is extra cost, typically borrows prices will be higher as well relative to other higher volatile tickers (at some brokers). This also requires some thought input on adjusting or perhaps even shifting brokerage if necessary.

Conclusion: Markets hate high inflation or inflation spikes

Historically it has been well proven that when there is a surge in inflation and monetary conditions toughen the markets start to struggle. This period typically lasts more than a year, but the maximums can be quite different as some inflationary periods are shorter (3 years) and some are longer (10 years). The idea is not to be guessing when it should end, but rather to watch market conditions closely along with central banks’ actions to see it in realtime when a major shift begins. If you know what to track you can’t miss it.

Inflation reduces valuations and prices of assets when it is uncontrolled high inflation (well above 2%). This increases the bleed effect on many assets as they become less competitive especially small-cap assets. Understand what this means for long-term prices and balance sheets of many smallcap companies. I believe that over the next year, we will see fundamentally many of the companies worsen in their outlooks, balance sheet quality (if you can dare to use that term with small caps) and therefore leading to fewer projects in the pipeline and less excitement.

That is a projection that might turn around possibly only once markets get a breather from the inflation and the recession finally unfolds and is behind us. Until then, less tickers in play, cheaper ones, and more expressed edge on the short side of smallcap trading. The amount of ADFs tickers (all-day faders) should further increase. This means if you are trading on the short side one will face fewer opportunities but possibly a clearer edge. If you are trading on the long side the opportunities should decrease but so should the edge and especially the big payoffs on big movers as those will be lesser in numbers.

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• Source: https://www.tradethematrix.net/post/small-cap-stocks-macro-situation-and-2023-overview