Will a recession follow the economy? Most sought-after investments, small caps lagging behind.

Chart of the week

The diagram shows an index of the most important leading indicators (LEI) and economic performance in the USA since 1974. In all blue phases, the LEI shows economic growth and in the red phases, economic contraction. This is confirmed by the black line, which shows economic output. The gray bar in the background highlights all periods of recession.

Why this is important
Since 1974, all periods in which the LEI was strongly negative and economic output declined have been followed by a recession. Since March 2023, many investors have been expecting a recession, but the economy continues to grow.
That is currently the big puzzle. Even with a recession looming, consumers are buying like there's no tomorrow. Corporate profits are also rising.

The chart shows that analysts in the USA (S&P 500), Europe (STOXX 600) and Japan (Topix) make more adjustments for higher company profits than for lower company profits. In a looming recession, the opposite should be the case.

Only in the emerging markets (MSCI EM) do expectations look poor. Here, most analysts expect corporate profits to fall.
Is the recession coming or not? Two important indicators (LEI and corporate earnings) contradict each other.
We are convinced that a recession will follow. Since the US central banks have existed, they have raised interest rates 15 times to combat rising inflation. 14 times they have overdone the rate hikes and a recession followed. Only once, in 1993, did they achieve a soft landing.

Most popular investments

The chart shows how much investors are investing in money market funds. Money market fund holdings have risen to an all-time high. Many institutional and private investors are parking money in money market investments or 6-month bonds. This is certainly also due to the inverted yield curve. Short-term investments have a higher yield than long-term deposits.
If even a fraction of this money flows back into the stock market, this will trigger a major stock market rally.

The chart shows how many investors invested in which equity sector last year. The technology sector stands out in particular. Almost all new money flowed into just this one sector in 2023. The majority of sectors saw outflows of money.

Should money flow out of money market investments, it is to be expected that this money will tend to flow into the sectors that have been left behind.

Small caps left behind

The chart shows the yields of small caps in the USA in the various phases in which the Federal Reserve has raised interest rates. The vertical line in the chart marks the date of the first interest rate hike by the US Federal Reserve.
In almost all previous interest rate hike cycles, small caps have held up well or even gained. Only in 1974 was the yield worse. However, 1974 is precisely the rate hike cycle that is often used as a possible development for the current cycle, as it has many parallels with the current situation. This is why we are not yet investing in small caps.

The chart shows the return of small caps in relation to the NASDAQ technology index since 1987. Small caps are currently even more undervalued compared to the NASDAQ than before the dot-com bubble burst in 2000. There are increasing signs in technical financial market analysis that a turnaround could happen soon.

Meme stocks are a special type of small caps. A meme stock is a stock that gains popularity among private investors through social media. The popularity of meme stocks is usually based on internet memes shared by traders on platforms such as Reddit. Examples of such stocks are Gamestop or Tupperware. These stocks often have strategic or financial problems and are rarely bought by institutional investors.

We strongly warn against investing in such stocks. These shares have also lost up to 75% of their value compared to their 2021 highs. Adventurous price jumps are possible in the short term, but investments in meme stocks do not fit into a long-term investment policy.