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The ‘eye of the storm’: SocGen says it can’t warn about stock-market problem enough
By: MarketWatch | January 17, 2019

Critical information for the U.S. trading day

In one of the last interviews he gave before his death Wednesday, Jack Bogle was heard telling investors to play it safe.

There was no sky-is-falling talk from the godfather of low-cost index funds, but his advice to get in your comfort zone over stock exposure interview was prudent, given that it came just days after a holiday meltdown for stocks.

He also mentioned “clouds on the horizon,” with trade tensions among them, and that old saw is threatening to make a mess of the action Thursday. Reports U.S. feds are probing Huawei over alleged stolen tech secrets have forced some cheer out of the building, with the safe-haven yen USDJPY, +0.20% seeing some duck-for-cover action.

As well, there may be just too much idle market time between Morgan Stanley results and Netflix after the bell today.

Back to Bogle, who haunts our call of the day from Andrew Lapthorne on Société GLE, +0.53% quantitative analysis team. The analyst warns that U.S. small-caps will be in the eye of the next storm for stocks, owing to the huge amount of debt they’ve been racking up for years. Corporate debt was another horizontal “cloud” mentioned by the Bogle.

Banks like SocGen have been banging the table on this one, Lapthorne said in a phone interview, adding that he’s personally had the subject on the radar for four years. His fresh warning came up in a recent presentation to clients given by he and the bank’s uber-bearish strategist Albert Edwards. In a clutch of charts, they rolled out this one showing a huge ramp-up in debt for the small-cap focused Russell 2000 RUT, +0.39% :



Small-caps have traditionally acted as a canary in the coal mine for the larger market, as they tend to be more sensitive to growth worries and usually show signs of fatigue before their big-cap counterparts.

“U.S. small-caps have been taking on a massive amount of leverage over the last few years,” particularly starting in 2013 during the QE years, notes Lapthorne.

“People focusing on buybacks were missing the fact that actually a lot of [companies] buying back significant market cap was going on in the small cap-index. The highly unusual reason that was happening is because people were having to lend to real businesses,” he said.

So, the difference between where we are now versus 12 months ago, says Lapthorne, is that share prices have been losing ground, “and if you have leverage and your share price is weak, that compounds the problem.” On a 12-month basis, the Russell 2000 has lost nearly 8% against a 5.7% drop for the S&P 500.

And a small company with balance-sheet problems can’t do what the big boys do — go back to markets and do a rights issue. That ultimately leads to a higher bankruptcy risk and bigger risks for the economy, which gets harder to ignore. “Looking at the Fed’s reversal in policy it seems far more connected to what’s going on in credit markets and in terms of weakening companies,” he said.

Lapthorne says it doesn’t make sense that investors focus on bigger companies when it comes to looking for red flags for the overall market. “If you think about it, the S&P 500 contains some of the richest, best companies in the world, so why would you look to the richest companies in the world for signs of stress? You’re far better off looking at the poorest companies.”

He also worries that investors are on a path of companies that are going to really struggle owing to “big deterioration in profit growth,” which is now seeing the effects of a tax-induce surge of a year ago start to fade.

Here’s one last chart from SocGen that taps into another worry on the radar for investors — a recession threat. It shows that one in four U.S. stocks have 50% or more of their value erased in a recession:



Gulp.

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