A true contrarian play

Investment Analysis Clubs Macro Economic Trends and Risks
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https://www.wsj.com/finance/investing/small-stocks-bargain-85034233?mod=hp_lead_pos10

The Stock Market Bargain That’s Right Under Your Nose

Big tech stocks have dominated, but one part of the market is too cheap to pass up

By Jason Zweig, The Wall Street Journal, July 18, 2025

Will small stocks stink forever?

Little companies are supposed to earn higher returns over time than big ones, but that hasn’t been the case for more than a decade. Since the beginning of 2014, the S&P 500 has grown at an average of 13.2% annually; the Russell 2000 index of small stocks has gained just 7.2%.

Many people seem to be throwing in the towel. So far this year, investors have pulled $12 billion out of exchange-traded funds investing in small U.S. stocks, according to FactSet. Meanwhile, investors added $149.6 billion to ETFs that track large U.S. companies…

The market value of the five biggest companies in the S&P 500 is nearly five times the combined market value of the Russell 2000 index, according to Steven DeSanctis, an equity strategist at Jefferies. In fact, Nvidia alone—at its recent market value of $4.22 trillion—is 65% more valuable than all the stocks in the Russell 2000 combined.

The 6.6% annualized total return on small stocks over the past 10 years trails large-company performance by 7.3 percentage points, says DeSanctis. (All figures include dividends.)

That’s the widest gap going back to 1935…

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In 2008, the worst year of the global financial crisis, the S&P 500 fell 37%. The Russell and S&P small-stock indexes lost 34% and 31%, respectively… [end quote]

Well…that relatively smaller loss doesn’t exactly excite me. It’s still a humongous loss.

The chart shows how overpriced the SPX is and vulnerable to the bubble popping.

Bonds yields generally fall during recessions since there is less business demand for lending. This increases the value of existing bond portfolios. This can be seen during the 2008 - 2010 and 2019 - 2020 periods.

The true contrarian play – if the investor expect the stock market bubble to pop – is to buy bonds since their yields are the highest since the financial crisis. Not risk assets like stocks (large or small-cap) which will fall during a recession.

Wendy

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Given the nature of the regime, seems that big companies, with deep pockets, would be favored. But look at the collapse of health insurance stocks. Insurance companies are nothing but a big pile of money with which to buy favor. How, where, are they failing?

On the CBS “news” tonight, was a report on the double whammy coming for people who buy in the ACA exchanges, a combination of rising premiums and reduced tax subsidies, yielding, supposedly, net increases in cost to the consumer of 75%. The takeway is that millions of relatively healthy people will drop coverage…recall, the coverage mandate of the ACA was repealed some years ago.

How did this happen?

Steve

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I always cringe when people think of bonds as “safe”. The risks are different, but they are still there. I do not claim to be a bond expert, though I’ve owned a few bond funds over the years (and took a bath on one of them when bonds went south in the early 2000s). With the US credit being downgraded, that doesn’t fill me with confidence about US bonds in general. And, not to be intentionally political, the current administration is sufficient inconsistent and chaotic, that US bonds seem to me to be riskier than they have ever been (i.e. who know what they might do that could affect bonds).

Not that equities are any more safe from the whims of an unpredictable administration.

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While the market is expensive, it can still go much further. Will it? Who knows, but in the past this was just the beginning. IBD just had a video out where they looked back at 1996 when Greenspan’s over exuberance speech came out.

You can see just how much further it ran. It doubled before dropping, so who knows what will happen?

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@1poorguy you make good points.

The lowest risk is to construct a ladder of bonds and hold them to maturity. Assuming the borrower does not default the bond’s interest payments and principal are predictable.

Bond funds are not the same as a bond ladder. A bond fund does not have a maturity date so the NAV (net asset value) can drop and the investor can take a bath.

Even if U.S. bonds are riskier than before this will affect their value only when they are bought and sold before maturity. This is why a well-constructed bond ladder will provide enough income that they can all mature sequentially and none of them will need to be sold.

If the bond market believes that inflation will increase and/or the government will issue more bonds than the market is willing to absorb at a certain price the market will adjust by raising interest rates. This will decrease the value of bonds in a bond fund or a portfolio of bonds. But the portfolio of bonds will return full principal if the borrower does not default.

I don’t expect the U.S. government to default. However, many governments in the past have printed money to pay for debts (equivalent to forcing the Federal Reserve to buy bonds to suppress their yields). This has led to inflation and even hyperinflation in the past and currently.

If interest rates rise the maturing bonds in the ladder can be re-invested at the higher interest rate.

Wendy

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However, that principal will have lost value due to the inflation. Over the last five years that would have been a 25% ding.

DB2

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Except for TIPS and I-Bonds which are inflation-adjusted.
Wendy

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Could you explain the benefit of I-Bonds? There is a fixed rate portion (currently 1.1% and an adjustable portion which changes every six months. The current sum is 4%. Since the interest rate changes every six months, why not just buy a six-month CD (which currently can be as high as 4.45%)?

DB2

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The I-Bond is a 30-year bond which can be cashed in at any time for full face value regardless of the prevailing interest rates.

When you buy a 6 month CD the rate will fluctuate parallel to the 6 month Treasury rate. When the Federal Reserve cuts the fed funds rate the CD rate will plunge as it did in 2020.

You will have to roll over the CD every 6 months. Because inflation changes independently of the CD yield the real yield will often be negative (the inflation rate will often be higher than the CD yield). The Federal Reserve only reports real yields for the 10 year Treasury. It was negative for long stretches.

When I bought I-Bonds in September 2001 the fixed rate was 3% (plus the inflation-adjusted rate). I also own TIPS with a yield of 2.0 - 2.5%

This is not a great investment but it is a safe investment. Metaphorically, the foundation of a house doesn’t have to be fancy but it does have to be solid.

Wendy

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But you can only put 10,000 dollars a year into it, so to build your foundation it could take decades.

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There is a limit on the purchase of I-Bonds. There is no purchase limit on TIPS. TIPS can be bought in any amount from Treasury Direct and on the secondary market via a broker such as Fidelity.

Wendy

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A long time ago, when I was younger, I mused to someone “what if we just cancel the national debt…what’s anybody gonna do, nuke us?” I doubt the leadership of the current administration has any better understanding than I did at that time. What’s to stop them? I’m sure they will be told it’s a bad idea, but they might not listen. They didn’t on tariffs.

They already let us get downgraded, I don’t think they noticed or cared.

Right now my only bond exposure is in a couple of “balanced” funds I have in my IRA (target date retirement…I think 2028 target). And I let the fund manager worry about which bonds he/she owns, so I don’t know what’s actually in there.

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Well, the bond market noticed. Bond investors care. The risk is part of the reason that Treasury real yields are in an upward slope.

The Treasury auctions bills, notes and bonds regularly.

Individuals, corporations, partnerships, government entities, trusts, and foreign and international monetary authorities are all eligible to bid at Treasury auctions. Bids can be submitted either non-competitively or competitively, with certain limitations on the bid amounts. Competitive bids specify the rate or yield they are willing to accept. There is a maximum limit of 35% of the offering amount for competitive bids. Government-related entities and foreign and international monetary authorities can participate along with 24 primary dealers (financial institutions such as large investment banks).

Since no bidder can buy more than 35% of the offering the final interest rate is set by the consensus. The yield moves inversely to the price.

If bidders think the risk is increasing they will bid less. This will cause the interest rate to rise.

What’s to stop the government from canceling the national debt? This was answered by Alexander Hamilton before the Constitution was even approved.

Stiffing lenders will cause them to shut off the tap. No more borrowing, sorry!

That’s the path to hyperinflation. It’s happened before but never in the U.S. which has always repaid lenders regardless of the hardship to everyone else (such as Revolutionary War veterans).

Hopefully our leaders will know enough to avoid that mistake.
Wendy

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That seems an unwise expectation!

JimA

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Any whiff of a suggestion of default on U.S. Treasuries (including a charge on foreign countries holding Treasuries which would constitute a partial default) could cause interest rates to rise.

The OBBBA, which was signed into law last week, contains a Section 899 which * specifically modifies the application of the Section 892(a)(1) exemption for foreign governments (including sovereign wealth funds) of “offending” foreign countries.

  • This means that if China were deemed an “offending” country, the investment income received by the Chinese government (e.g., the People’s Bank of China, which holds a significant portion of U.S. Treasuries) could become subject to U.S. tax.

While the “portfolio interest” exemption generally covers interest on U.S. Treasuries, the modification to Section 892(a)(1) for “offending” foreign governments could potentially override this for governmental holdings. The exact scope of “investment income” that would be affected for foreign governments under Section 899, beyond directly disallowing the general Section 892(a)(1) exemption, would likely require further Treasury guidance. [According to Google Gemini.]

China’s holdings of U.S. Treasury bonds were approximately $757 billion in April 2025 . As of April 2025, China was the third-largest foreign holder of U.S. Treasury debt, behind Japan (the largest) and the United Kingdom.

This is a situation of “we aren’t going to hurt each other, are we?”

The U.S. could decide to “punish” China by declaring it an “offending” foreign country and taxing its Treasury interest. But then the Chinese could decide to stop buying Treasuries. (They have already gradually reduced its holdings of U.S. Treasury securities since 2018, diversifying its foreign exchange reserves, including increasing its gold holdings and optimizing its portfolio to balance different currency-denominated assets.)

The price of Treasuries (which moves inversely to their yield) is established by auction. If one of the strongest bidders withdraws demand at the same time that the U.S. government deficit is rising the price of Treasuries will decline and yields will rise.

I hope that the Secretary of the Treasury will explain to President Trump that the fed funds rate has very little impact on long-term Treasury yields which are set by the bond buyers at auction.

Meanwhile, the OBBBA has been signed into law and real Treasury bond rates (as shown by TIPS yields) are rising.

Wendy

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